Stock Market Analysis
Stocks fell last week with the Dow slipping 0.4% while the small cap Russell 2000 slumped 3.5%. Twice as many stocks fell as rose and we saw nine times as many stocks hit new lows as new highs. Healthcare and Basic Material stocks were the hardest hit while defensive issues like Non-Cyclical and Utilities actually rose. Surprisingly, Cyclical stocks have been the only sector to see gains this year. It should be no surprise that Energy stocks have seen losses of over 20% year to date.
In our Economic Outlook for 2015, we had suggested investors prepare for volatility in 2015. We noted higher valuations and excessive enthusiasm were risks to the smooth sailing of the last three years. In addition, we have reported that Quantitative Easing (QE) helped support stocks since 2008, but hurt stocks when we went through periods without QE. The Fed ended QE last year and the market is trying to figure out how stocks should really be valued. Lastly, earnings growth has slowed, making proper valuation even trickier.
This past week we posted a special study called “China is not Greece.” The study and a brief video are posted on our website. In the study we pointed out that Greece is a tiny country and had the full support of Europe. By comparison, Greece is only about 2% of the Chinese economy. China had seen 14% annualized growth since the 70s, but growth recently slowed to about 6%. Commodity prices and low international inflation reflect this slowdown. Leaders in China are trying to stimulate their economy with interest rate cuts, government spending and changes in stock trading rules. They have not had a lot of experience with “free markets” so their efforts bear watching. Nonetheless, we expect heavy competition from China and their market volatility will affect our market as well. In our study we stated, “We think it is prudent to reduce this financial instability. To offset this, we believe it is appropriate to temporarily dampen the volatility with somewhat lower equity positions.”
We wish to follow our indicators as they have proven to be the best approach for us to make wise decisions and overcome our normal human emotions about the markets. We continually review and revalidate them since the markets are constantly evolving as well. Because of the nature of the markets, it must be emphasized that a strictly mechanical approach to investing can only work some of the time.
It is important to remain humble in the face of the markets, to keep an open mind and to use common sense. We have recently completed one of our periodic reviews and we believe it will be of help to us in navigating the markets. Our most powerful indicators are no longer favorable and we suggest gradually lowering equity levels somewhat to adjust for China and domestic risks.
Barry R. James, CFA, CIC
Bond Market Analysis
Bond prices slipped this past week. All major bond sectors, except Municipal Bonds, fell. High-Yield bonds fell the most, losing 1.4%, while longer-term Treasuries fell about 0.3%. Bonds have been bouncing around a lot in the last year. Over the last 12 months, long-term Treasuries have gained 7.5%, but in the last six months they have fallen 5.6%. Surprisingly, in the last three months they have gained 4.5%, while losing 1.2% in the last month. The only trend is no trend, other than sharp moves in bond prices.
Of course, Fed action/inaction had a major influence on bonds in the last year. We had previously researched Quantitative Easing (QE) and its impact on bond returns. We found that during periods of active QE, longer term bond yields actually rose and prices fell. On the other hand, when the Fed curtailed active QE, those same bond yields fell while prices rose. Thus, in the early days of ending QE, bonds had a powerful run, but as time as gone on, the markets have had to process other factors in determining interest rates. Throughout the summer, that factor was primarily speculation about when the Fed would start raising interest rates.
Fed Chair Janet Yellen and her Federal Open Market Committee had signaled rates would be rising in the fall, but in their latest meeting they said they remain focused on jobs and price stability. They were concerned with global instability and the possible repercussions to the U.S. economy. They decided to hold back on raising rates which should not surprise those who follow our analysis. After all, the Fed’s own measure of the overall job situation is at such low levels it is more associated with rate cuts than rate hikes. In addition, the Fed’s favored inflation gauge, the Personal Consumption Expenditures (PCE) Index shows inflation at 0.3%, well below their 2% target. Yellen did say they still intend to raise the Fed Funds rate this year and we should expect they will eventually do so.
As the market starts to adapt to this mindset, we should expect to see a flattening of the yield curve, with short term rates beginning to rise and longer rates remaining more stable. Historically, it has been better to work toward a “barbell” approach with bonds during these times. That is, having a larger portion of the portfolio in short term bonds, where rising yields have a relatively small impact on bond prices, and having the remainder of the portfolio in longer term bonds, which might take advantage of the change in the yield curve. This is different than a “bullet” construction, which has most of the bonds in just one maturity range.
Bonds have been a place of refuge as the stock market has become more volatile. However, they seem to have crossed a significant threshold. For many years, we thought the risk/reward tradeoff favored bonds over stocks. When an exogenous event, like QE, is eliminated, then a better analysis of this tradeoff can be made. Looking to the next 10 years, bonds just do not offer that same profile and investors need to focus on how to best take advantage of this change. We have lowered overall durations to neutral, we have diversified our bond holdings across various sectors and we are now gradually working to barbell maturities. Bonds may still provide a haven at times, especially when a major crisis arises, however, their thirty year run is starting to reverse.
Barry R. James, CFA, CIC
