Stock Market Analysis
The unofficial end of summer seemed rather lazy for stocks. The Dow Jones Industrial Average, for example, gained less than 100 points on the week. However, smaller stocks, like those of the Russell 2000, enjoyed a total-return gain of over 1.1%. Over the last three months, in quiet fashion, small stocks have taken the leadership role. On a sector basis the best gains for the week occurred in the Finance and Basic Material arenas while Energy and Healthcare securities lagged.
Where does the market go from here? We have some significant concerns. Earnings, which represent the life blood for most companies, have been anemic for some time. According to data from Bloomberg, earnings for the S&P 500 peaked in September 2014 and are now down over 12% from those levels. Similarly, revenues are also lackluster and we have seen negative growth in the last two quarters. This has led us into a sales recession.
Valuation levels are also a concern. Presently the S&P 500 has a Price-to-Earnings (PE) ratio north of 20 which is historically expensive. Looking at Price-to-Book the picture is eerily similar with stock prices almost 2.9 times higher than book value (assets - liabilities). Clearly, some stocks, especially larger ones like those in the S&P 500, appear expensive.
While real, these concerns will take time before the market finally digests them. The overall stock market is in a long topping phase but it still shows some signs of continuing.
While some of the popular indexes posted a quiet advance last week, the cumulative advance - decline line set a new record high. This is positive because it suggests the market enjoys broad support and is not limited to a few mega-sized corporations.
Another sign of encouragement is the continued level of Wall Street skepticism. The American Association of Individual Investors (AAII) survey actually has more bears than bulls. The Put / Call Ratio is also on the rise suggesting investors may be too cautious. Analysts are also becoming more pessimistic. Starting in 2007 analysts typically had 10.5 buy recommendations for every one sell recommendation. Today? The ratio is down to 7.5-to-1. Currently we don't see excessive enthusiasm which is typically seen at a market top.
Our leading indicators are neutral at best. While they had pointed to an excellent buying opportunity at the time of the "Brexit" vote, they are now saying that opportunity has past. However, this is not to say a peak in stocks is imminent. During this phase it may make sense to hold a good portion in smaller cap stocks which have recently taken the leadership role in stocks.
David W. James, CFA
Bond Market Analysis
The week of the employment report can bring volatility to the financial markets. This was not the case for bonds this week. Many types of bonds managed to advance on a total-return basis, but most of those gains were meager. The major exception came from long sovereign (foreign government) bonds which fell almost 2% on a total return basis.
In looking to the future it is important to consider the economy. Often a poor economy leads to favorable returns for higher quality bonds. The reverse can also be true with bonds lagging during strong economic growth. So what should we expect?
One area of importance is the Personal Income, Spending and Savings Rate. These are all important as they suggest the shape the consumer is in and what actions they are taking (spending or saving) with their money. As consumers make up approximately two-thirds of our economy they clearly are worth following. According to data from Bloomberg News we find since 1959 these three key areas follow the "Rule of 7" meaning disposable income and spending usually grow around 7% a year and that the consumer's savings rate is over 7%. These are the numbers we need to see to suggest a good consumer situation.
Regrettably, this is not where we are presently. Disposable income is only growing at 3.6%; roughly half of what has been normal. Spending is slightly better, but only slightly, as the year-over-year number is a discouraging 3.8%. The best showing comes from the savings rate which stands at 5.7%. Even here we see discouraging signs as the savings rate is below levels we had seen six and 12 months ago.
Manufacturing also remains a sore spot for the economy. The Federal Reserve regions from New York, Philadelphia, Dallas, Kansas City and Richmond (Virginia) all offer reports, either positive or negative, of manufacturing in their perspective areas. Four of the five regions had negative reports. Examining new orders for manufacturing in these regions offers similar results; manufacturers are dealing with tough times. Disquietingly, there are now over 1.8 government jobs for every 1 manufacturing job.
Speaking of jobs, Friday's report was underwhelming. The payrolls number suggests 151,000 jobs were created last month giving us 2.4 million jobs created in the last 12 months. The problem is our adult population grew by 2.7 million. Not enough jobs are being created. One reason for this is the declining number of entrepreneurs who are often the job creators in our country. Last month we lost 39,000 from the entrepreneur class.
For bond holders this may be significant. Looking back to 2000, our analysis suggests the 10-Year Treasury has seen more than twice the annualized return when we lose entrepreneurs as opposed to when the number of entrepreneurs was on the rise.
Presently our leading bond indicators remain favorable. While we expect some fluctuations, the current prognosis is for lower interest rates in the upcoming months. We would maintain a moderate to slightly aggressive duration in higher quality bonds for most investors.
David W. James, CFA