Stock & Bond Market Update (6/1-6/5)

Stock Market Analysis

Mixed messages, I hate mixed messages. But that is what the market is giving us. The Dow fell last week and is only ahead 1.25% for the year. On the other hand, small cap stocks, as represented by the Russell 2000, rose 1.18% for the week and are up over 5% this year. Unfortunately, more stocks fell than rose last week and we actually saw more new lows than new highs. We saw a similar mixed message with sectors as 3 of five advanced, while more defensive issues suffered.

The last three months have also been sending a mixed message. We analyze and rate stocks based on three areas – value, earnings and relative price strength. We look at about 8,500 stocks and when looking at the various sectors, half of them saw the worst rated stocks outperform the best rated stocks. In addition, while the S&P500 rose, the typical stock actually fell. We also saw lower rated stocks outperforming higher rated stocks (those over $500 million in market cap). This isn’t normal and is another mixed message.

The same is true of factor analysis. Usually we talk about how value factors either worked or did not work. This time, they did both. It was just a matter of what individual factor you follow. For example PE (Price/Earnings), where we look to see how much we have to pay to get $1 worth of earnings, worked in reverse. This means the most expensive PE stocks did best. BUT, when looking at Price/Book, which compares stock prices to an accountant favored value called “book”, the opposite was true. The cheapest stocks did the best. Mixed messages.

Lastly, when it comes to stocks, prices have gradually trended higher but sentiment is decidedly mixed. Advancing issues no longer outnumber declines to the extent they should in a good rally. Some data suggests sentiment among investors is excessively favorable and caution is lacking. Over the years these patterns often precede limited corrections. Accordingly we are starting to prune those equity issues with the least potential. Our intermediate term indicators remain mostly neutral so we don’t see significant risks of a 2008 type melt down for stocks. In this environment, individual stock selection and good diversification provide the best opportunities.

Barry R. James, CFA, CIC

Bond Market Analysis

A rough week for bonds. Long term treasuries slumped 4.3 percent, long term corporates slid 3.4% and the best sector was high yield bonds which fell 0.8%. Year to date, losses are racking up in longer term bonds while intermediate term bonds are still in positive territory. It may seem strange, but Greece is actually having an impact on our bonds.

When Greece looked likely to default, many were rushing to the safety of U.S. Treasury bonds. In addition, even though rates were fairly low, the dollar was strong, giving further reason to hold U.S. bonds. However, we have been undergoing a sea change, with the dollar losing ground in the last week and so far this quarter. While Greece delayed a payment to the IMF, we are rapidly coming to the end of the line. They have a hard time accepting austerity since about 1 in 3 people are dependent on government jobs and 25% of the youth are unemployed. The war of words will continue, but if Greece leaves the European Union, it would be hard to see how it wouldn’t make the EU stronger. In the end, this could drive foreign investors away from U.S. bonds.

Inflation is one of the key drivers of interest rates. Right now the Personal Consumption Expenditures index is running at 0.1% over the last year, but taking out food and energy it is 1.2%, which is well below the Fed’s target of 2%. On the other hand, investors are demanding protection against inflation of about 1.8%. We are starting to see some worrying signs though. Productivity fell 3.3% and Unit Labor costs surged 6.6% in reports last week. This may be early signs of wage inflation, which is what the market really fears. I have a friend who works for FedEx and he said they had an unanticipated pay hike and were told to expect more still this year. Those working in skilled positions are seeing some support in higher wages. This will bear watching.

Lastly, the employment report was good news for those looking for work, which means bad news for bonds. The number of new jobs was higher than expected, but in a twist, the higher unemployment rate was actually positive news. This time it meant more folks were starting to look for work. The report also had good news on wages, as average hourly earnings advanced nicely.

We are in a transitional period for bonds, and our short term indicators suggest the current pullback in bonds could continue. However, Scud missiles and expanding attacks in Yemen may make U.S. treasuries attractive again. Our intermediate term indicators are not negative so we wouldn’t abandon moderate durations in high quality bonds.

Barry R. James, CFA, CIC