What happened in the stock/bond markets last week (6/22-6/26)?

Stock Market Analysis

The Dow fell 0.38% last week. We also saw similar losses in smaller cap stocks. Overall we had more stocks fall than rise but we still had more new highs than new lows. Six out of 9 sectors fell, with Utility and Basic Material stocks doing the worst. Cyclical and Healthcare stocks held up the best. Healthcare should be no surprise given the Supreme Court’s decision upholding subsidies.

Year to date, six of nine sectors are up with Healthcare and Cyclical stocks doing best while Utilities have had double digit losses. Given the losses in bonds, it is easy to understand the problems Utilities have had. The wide difference in sector performance is a good indication of a market in transition. This year, Healthcare stocks are up over 11% and Utilities have lost 10%. It is little surprise the market has made such modest progress. However, the transition is starting to show itself in small cap stocks, with the Russell 2000 Small Cap Index rising almost 7%, more than doubling the large cap S&P 500 Index.

Indexing has become all the rage, as it usually does after a 6 year bull market. At the Morningstar conference this week, much was made of the big shift to indexing – about one third of all investments are now passive – meaning folks have given up on trying to outperform and are willing to take whatever risk the markets offer. Our philosophy has always been to try and take the least amount of risk that will accomplish the goal of the investment. Our approach has been to try and build a portfolio that will minimize losses when the inevitable correction comes, at the same time, we don’t want to eliminate upside potential.

As such, we have built our stock portfolios with more even weighting by sectors and by size. These work well over time, but don’t work in every season. Still, after 43 years of experience, we have seen this to be the approach that works best for us. In addition, we look for stocks offering good value, excellent earnings and a solid rising price pattern. Even here, these factors don’t always lead the pack. In fact, in the three months ending May, the most expensive stocks by PE (Price/Earnings) outperformed the cheapest ones. Historically our approach shows excellent differentiation in about 3 out of 4 quarters and we are staying with our discipline.

As mentioned last week, the market here seemed to be following the Greek market. We can expect more turbulence this week, as the European Central Bank has frozen lines of emergency loans to Greece. Fear has been pervading the markets, with major investors like Carl Icahn and Bill Gross giving warnings. Oddly enough, we prefer to buy when fear grows and our intermediate term indicators are positive and our short term indicators have improved. We are looking at any setback as an opportunity to add equity to underinvested accounts.

Barry R. James, CFA, CIC

Bond Market Analysis

In a reversal from last week, this one was terrible for bonds. Long term treasuries slumped 3.2% and long term corporates 2.6%. All sectors of the bond market fell, with the best performing, high yield, still losing 0.2%. The year has been a reversal of 2014 with long treasuries losing 7% instead of rising over 20%.

This is somewhat strange, in that the May CPI report showed 0% inflation over the last year. In addition, the first quarter GDP report was negative. Problems abroad should be good for our bonds. The Greek tragedy continues and we had terror attacks in multiple locations. We also saw the dollar strengthen and the treasury auctions go well last week. Lastly, our interest rates are still higher than those in Europe, making our bonds more attractive.

Given all the reasons for rates to fall, why did they rise? In short, investors think the economy is going to accelerate and the Fed is going to raise rates. They see signs of life in the jobs reports and in all the help wanted signs around. We are finally seeing wage growth, especially in the area of skilled labor. We are also starting to see it in some areas of unskilled labor. IKEA just announced a hike in the minimum wage at their stores, seemingly a growing trend.

While the Chicago Fed report was negative, existing home sales jumped more than expected, up 5.1% in May and 9.2% over the last year. In addition, home prices have risen 7.9% over the last year as well. As I’ve spoken with realtors, and they are seeing a great market, with homes selling quickly and a lack of inventory. Housing strength extended to new homes as well, exceeding expectations. Mortgage rates have been historically low and the uptick in rates may be triggering the swell in buying. In addition, an improving jobs environment aids housing sales.

Our short term indicators are negative but our intermediate term indicators are favorable. We remain in a transitionary period for interest rates, they should remain volatile but we don’t think rates will head straight up. Holding a modest position in high quality bonds provides a safety net and could be helpful if problems continue in Greece.

Barry R. James, CFA, CIC