Stock Market Analysis
The market pulled back last week with the Dow falling 0.49 percent and the small cap Russell 2000 falling 2 percent. Twice as many stocks fell as rose but over five times as many set new highs as lows. More defensive stocks did better, with the Utility, Telecom and Healthcare rising while Basic material and Energy stocks fell the most.
It is not surprising the market pulled back some last week. We have seen a 12.2% jump in the Dow since the low on 11 February. Rallies need to let off some steam at times if they are going continue. The good news has been the shift in the market. While growth had been the king relative to value, in the last twelve months we have started to see a change. This has been true with Large caps stocks but not to the degree we have seen with smaller stocks. According to Barron’s, Mid Cap Value had returns of -3.9% vs -11.3% for Mid Cap Growth. A similar pattern is true for Small Caps with Value doing -10.5% and Small Growth doing -14.3%.
The Federal Reserve made a change in their stance toward 4 rate hikes in 2016. They now say they are likely to only make two of them. We heard a Senior Regional Fed Officer speak at Wright State University and he made a couple of things clear. First, inflation is too low and business investment and exports have been too weak. We concluded they are not looking to jack rates up anytime soon. In addition, it does not look like a new round of Quantitative Easing is in the cards. If this is the case, stock prices will more closely follow valuation and earnings as opposed to Fed stimulus. As such, with somewhat elevated valuations and three quarters in a row of falling earnings, we should expect stocks to remain vulnerable to outside shocks and we wouldn’t anticipate a new bull market to be starting anytime soon.
The election will be given extra play in the headlines with regards to stocks moves. In reality, stocks will reflect the overall risk analysis of investors and we would not put too much weight on political talk. The economy is more pressing and fourth quarter growth of 1.4% is not going to set the world on fire. The profit report from the fourth quarter was quite morose. Currently, the GDPNow estimate from the Atlanta Fed is running at 1.4% as well and estimates are for profits to take another hit in the first quarter.
In looking at risk indicators, the Volatility Index (VIX) is no longer suggesting low risk for stocks. In addition, the Put/Call ratio is not as fearful as we like to see. Lastly, insiders recently pulled back from being bullish and had been using the rally for some selling.
Our risk indicators are unchanged from last week and that usually means no change in direction. However, there are still signs of caution. In this environment, especially the underwhelming profit and revenue picture facing many corporations, investors should focus on maintaining positions in companies offering good relative value.
Barry R. James, CFA, CIC
Bond Market Analysis
The holiday shortened trading week generally saw higher yields with the 10-Year and 2-Year Treasuries seeing their yields rise 3 to 5 basis points, respectively. It seems even lower quality (high-yield) bonds were not immune and their prices fell during the week as well.
Some of this may be in response to recent Fed members suggesting rate hikes could come as early as April due to a strengthening economy and labor outlook. While the Fed can certainly take any action it wishes, investors would be wise to examine the data before making decisions.
There are some signs of an improving economy. We can, for example, review the regional Fed reports on manufacturing looking specifically at new orders. In the latest month four of these areas (New York, Philadelphia, Virginia and Kansas City) have all changed from showing contraction to growth in new orders. Certainly this is a good sign.
Balancing this, however, is the Capital Goods report (excluding defense and aircraft). This is often used as a proxy for business investments. We find this number, on a year-over-year basis, is contracting and suggests an ill ease by the business community to expand.
The overall economy continues its unimpressive course. Industrial Production, which is perhaps the best monthly gauge for the economy, is declining. The fourth-quarter 2015 GDP number was revised slightly higher but still could not top 1.5%. As Barry James, President/CEO of James Investment Research has previously noted, “If the economy is growing by 2% or less it is going to feel like a recession.”
And, what of the Fed? For an organization that is supposedly data-dependent they should closely review their own data. Their National Activity Index, which tracks 85 separate indicators, is negative. The Fed’s quantitative department has developed a forecasting tool to predict GDP called GDPNow. GDPNow currently suggests first-quarter 2016 economic growth will be another tepid reading of 1.4%. The piece-de-le-resistance is the Fed’s own Labor Market Conditions Index report. Instead of looking at just one or two labor factors like payrolls or the unemployment rate this index examines 19 separate labor market variables. The last two monthly readings have been negative, not positive.
Overall we note an improving picture in our intermediate-term bond indicators. It would not be surprising in the coming weeks or months for investors to again seek the sanctuary of higher quality bonds. For now we would maintain a position in these higher quality bonds while maintaining a moderate duration.
David W. James, CFA
