April 25, 2016 - Here's what happened in the stock/bond markets last week

Stock Market Analysis

Stocks fell last week. Large stocks (S&P 500) and small stocks (Russell 2000) both fell over 1.2%. Volume ran 6% heavier than last year’s average and the heaviest volume was reserved for down days. This may suggest growing caution among traders. Further, we note six of nine major sectors lost ground with Technology and Healthcare both down over 3%.

Stocks are starting to suffer from a lack of enthusiastic buyers. There are perhaps no more ardent stock cheerleaders than those who borrow money just to buy more shares. We can track this by following changes in margin debt. As long as margin debt is on the rise, the bulls can feel comfortable the good times will likely continue. However, when these cheerleaders pack up their pom-poms and margin levels fall, it often signals the game is over. We saw this at major turning points for stocks in March 2000 and July 2007, which were followed by +20% declines in the S&P 500 over the next two years. The latest margin debt peak occurred in April 2015 and may have suggested the bumpy ride we have been experiencing.

Many companies are dealing with top-line (revenue) woes. Over 60% of companies have reported earnings for the first quarter and data from Bloomberg shows declining revenue growth in 7 of 10 major sectors. Put simply, this is not just a problem from energy stocks.

Why does this matter? Historically we have seen a solid correlation between business sales and changes in employment. Often, when businesses are unable to expand the sales of their goods and services, they look to lower costs through employee layoffs. Worse, this situation can create a vicious cycle. As employees feel less secure about their continued employment, they pull back on their spending and sales fall further. We already see some evidence of this. Personal spending over the last year grew only 3.5%, roughly half its normal pace since 1959. The good news is personal savings are on the rise and when conditions improve there may be a reservoir of cash for consumers to spend.

How should we invest today? Our intermediate indicators are deteriorating and suggest a more cautious approach. It makes sense to look for areas which may hold up better. Not all asset classes offer the same benefit. Examining our data on correlation and volatility it may make sense to consider areas like larger stocks, Utilities, precious metals and, of course, high quality bonds. We would lower equity levels and seek to hold volatility in check.

David W. James, CFA

Bond Market Analysis

It was a good week to own higher quality bonds. On a total-return basis long-term Treasuries gained 0.8% and are up over 7.5% so far in 2016. Yields fell across all maturities with the healthiest declines occurring in the 5 to 10 year range.

In examining the future of the bond market it is usually imperative to review the economy. Why? High quality bonds and the economy often move in opposite directions. Thus, a weak economy typically benefits bond holders. So what is happening with the economy?

Global economic woes continue, with much of it associated with the slowdown in China. Chinese GDP is printing at a 6.7% year-over-year rate. This is great compared with most of the world, but it is running about 30% lower than normal levels starting in 2000. The real numbers may be even worse. Nearly one-fourth of China’s economy is export dependent and freight container volume for exporting has fallen 30% in the last 12 months.

In their commentary this week, the Federal Reserve took no action but sent mixed messages about the future. They suggested they “may” raise rates at their next meeting. The futures market gives an 11% probability of this happening. Raising rates is their prerogative. However their own Fed Labor Index should give them pause. Presently this labor index (which tracks 19 separate factors) is negative. Our research has shown since 1976 the Fed cut interest rates 77% of the time following negative readings and only raised rates about 9% of the time.

Indeed, while favorable payroll numbers have captured the headlines we have seen a growing insidious shadow: announced layoffs. These are upcoming layoffs that may not have yet occurred. Data from Challenger, Gray and Christmas suggests announced layoffs, through the first three months of the year, are picking up steam. Recently these numbers show layoffs running 32% higher than 2015 and 52% higher than 2014. With the weak GDP report, it seems probable many of these announced layoffs will regrettably turn into reality. While unfortunate, this weakness would tend to preclude a major rise in interest rates.

We are just beginning to get indications of second quarter GDP. Both the Atlanta Fed and NY Fed have created quantitative models to project GDP. Atlanta’s model suggests economic growth of 1.8% for the second quarter while New York’s is more sanguine and suggests growth of 0.8%. Neither number is attractive but they both would represent an improvement from first quarter levels. Given how far bond yields have fallen this year, the market may have already factored this weakness into yields and so we may be a bit vulnerable to a bounce in rates.

One area worthy of attention is the municipal bond market. Puerto Rico is in the news with credit problems. According to Bloomberg News, the commonwealth is dealing with $422 million of debt that comes due as of May 1st. Moody’s, a well-recognized rating service, suggested last week that “...any non-payment, even if it’s agreed to by creditors, constitutes a default in their eyes.” Such talk could spook the entire municipal bond market regardless of whether the credit quality is good or poor. Such a snap judgment may provide investors with an opportunity to buy quality muni bonds at bargain prices.

Overall, our measures of risk suggest we should continue to avoid overly aggressive duration levels. We expect volatility to rise and recommend maintaining durations at or below recent target levels.

David W. James, CFA

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