What happened in the stock/bond markets last week?

Stock Market Analysis

Conclusions: To the surprise of the “perma-bulls” on Wall Street it apparently is possible for stocks to decline. Large and small stocks, such as those found in the S&P 500 and Russell 2000, respectively, fell over 2% on the week.

Much of the market’s recent woes stems from the prospect of a Fed taper in the not-to-distant future. The Fed is encouraging investors to seek relatively riskier investments by buying $85 billion of our debt every month. Should that $85 billion amount diminish the thinking goes that investors will begin changing their own asset allocation to reflect market valuations as opposed to extraordinary Fed policies.

So how do the market fundamentals look today? In many cases the answer is worrisome. Earning season is essentially over. Although many companies had earnings “beat” analysts’ expectations it is important to remember these estimates have been carefully managed and massaged by the companies themselves. A better gauge is to view the earnings growth itself. According to data from Bloomberg News earnings for the quarter grew at 3.5%. However when we back out the financial sector we note earnings actually fell 1.8%.

We also find traditional value characteristics to be at relatively high levels. The average PE for all the stocks in the S&P 500 stands at an expensive 24.5 and the price-to-book levels is a jaw dropping 4.6. These are not numbers associated with a cheap market

Additionally, economic conditions in the intermediate future are not promising. The National Federation of Independent Businesses (NFIB) surveys small business owners every month. Often these owners are very prescient about the future of the economy. The latest readings show small business owners expect the economy to contract rather than expand.

Why are the owners so pessimistic? Washington interference. When asked about the number one problem they faced small business owners answered clearly. It was not heavy competition or lack of sales. The owners responded the top problems are high taxes and too many regulations.

There is also concern about consumers. Consumers traditionally make up roughly two-thirds of the economy. A great way to understand consumer’s actions comes from reading the retail sales report, which was released this week. While retail sales did advance it happened on the backs of higher food and gasoline prices; not the making of a prime economy. Dubiously the big ticket items such as vehicles, furniture, electronics and building materials--all fell.

Our leading indicators are, unfortunately, firmly in the unfavorable camp. This often suggests risk levels are elevated. Recently there have been too many speculative buyers and the more cautious path remains a prudent strategy.

David W. James, CFA

Bond Market Analysis

Conclusions: U.S. Treasury bond yields ended the week higher due to worries that the Federal Reserve will reduce the amount of securities it purchases. However, on balance we think the economic data released this week was positive for bonds.

The National Federation of Independent Business released their most recent survey which showed that small business owners reduced their expectations for the economy. This is troubling because the owner’s forecasts were already subdued and historically they have been more accurate than mainstream economists. This is welcome news for bond investors as bonds tend to do better when economic growth is tepid and inflation is low.

Another positive for bonds lies in the report on labor costs and productivity. Labor costs dropped 4.2% in the first quarter and rose only 1.4% in the second quarter this year so overall labor costs are down thus far in 2013. Labor productivity increased almost 1% in the second quarter. Lower labor costs and higher productivity should help keep inflation at bay; again, this is good news for bond investors.

The highest quality municipal bonds continue to offer value especially compared to corporate bonds. The municipal tax-free equivalent yield compared to corporate bonds is higher than any time going back to 1979. Additionally, tensions in Egypt and across the globe have the potential to trigger a “flight to quality” which would help the U.S. dollar and high quality dollar denominated bonds.

One growing concern is the latest consumer inflation report (CPI) shows inflation is running about 2% over the past 12 months. This is up sharply from just three months ago when the 12 month increase was only 1.1%. Excluding food and energy, for those who do not eat or use energy, the reading was 1.7%. This is lower than the Federal Reserve’s target of 2%, but as Will Rogers said, “It isn’t what we don’t know that gives us trouble; it’s what we know that just isn’t so.”

Every financial planner will tell you to live within your means, but the U.S. government continues to ignore this advice. In 54 of the last 60 months the U.S. government has spent more than it has received in tax receipts. Unfortunately, the latest month was about average with the U.S. government spending almost 100 billion more than it received.

Our bond risk indicators remain favorable and continue to suggest advantages in bond positions over the intermediate term. We recommend a position in high quality bonds with modest durations where this is appropriate for client objectives.

Matt Watson, CPA