February 6, 2016 - Stock & Bond Market Analyses

Stock Market Analysis

It was another positive week for stocks. The large cap S&P 500 closed up 0.9% and set a new record high. The smaller stocks of the Russell 2000 also set a new record high and enjoyed a 0.8% gain. However conviction seemed to be lacking as volume last week was 15% lower than normal.

Earnings season remains pleasant. With approximately 70% of companies reporting, Bloomberg News reported this is the best profit growth we have seen in more than two years. The latest figures show earnings growth in excess of 5%.

However, we do find one area of growing concern: excessive optimism. Many of our indicators dedicated to measuring sentiment suggest too much optimism and correspondingly they have turned unfavorable.

For example, McMillan Analysis Corp. shows their three week put-call ratio is extremely low; historically a bearish sign. Similarly, the cash levels in institutional equity portfolios are at a low 3%. This suggests institutions may have already bought the rally and may not have the resources for a big push higher. A final sign of utter belief in this rally comes from a recent cover of Barron’s which proclaimed, “Next Stop, Dow 30,000”. Rarely are such milestones reached quickly when it has become the popular opinion.

There is one group, with a solid history of stock timing, which holds a different point of view. This is corporate insiders, a group we affectionately call the “smart money”. The latest data, collected by Thompson Reuters, shows insiders are selling 49 shares for every 1 share they are buying. Reuters notes ratios above 12, like we are experiencing today, are usually bearish for stocks.

Given the high level of optimism by Wall Street and the unfavorable configuration of our leading intermediate and short term indicators, we would suggest risk levels are somewhat elevated. While stock prices may go higher in the short term, we believe it makes sense to lower investor’s risk by lowering equity levels where appropriate.

David W. James, CFA

Bond Market Analysis

It was a good week for bond investors as yields for intermediate and long-term Treasuries fell. The yield on 10-Year U.S. Treasury notes ended the week at 2.41%, while the 30-Year U.S. Treasury closed at 3.01%. On a total-return basis the Barclays Intermediate Treasury Index gained 0.21% and long-term U.S. Treasury bonds advanced 1.66%. The U.S. Dollar rose 0.93% on the week against a basket of major world currencies.

The FED’s Labor Market Conditions Index returned to positive territory for January after it fell into negative territory in December. This index measures 19 different employment indicators and is highly correlated with the direction of future interest rates. The index has seen improvement in wages, business surveys and overall employment. Some headwinds for the labor index include layoffs and average weekly hours for employees. If the index remains positive this would suggest the next rate hike could be around the corner. In fact, the futures market currently forecasts a rate hike in June.

Last week the new administration indicated they plan to have a tax proposal out in the coming weeks. Bond investors will be watching closely to see the potential impact on deficits and future growth. Investors worry when deficits widen and the potential for growth and inflation increase. Last year bond yields soared and prices slumped when both candidates campaigned with stimulus plans.

Investor and consumer optimism continues to remain elevated even as inflation expectations inch higher. The University of Michigan inflation gauge for the next year shows an increase of 0.6% in just two months. The breakeven spread between the 10-Year U.S. Treasury Yield and inflation linked securities is around 2%; up 0.6% from a year ago. Higher inflation concerns and the optimism around future growth are weighing on bond investors and sending yields higher.

The bond market has been oversold for several weeks and bond investors took this as an opportunity to buy at discounted levels. However, our intermediate term indicators remain unfavorable for bonds. The recent rally may be a good time to adjust bond allocations where needed to get back to target levels. We would also shorten durations where appropriate.

Trent Dysert, CFA

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