Market Commentary by James Investment Research

This is syndication from jir-inc.com

Stock Market Analysis

Conclusions: The market hit a headwind last week as the S&P 500 index had its first weekly loss in 2013. The index fell 0.22%. The smaller stocks in the Russell 2000 index fared worse, slipping 0.74%. The basic materials and consumer discretionary sectors were hit the hardest as both were down over 1%. Volume was light for the shortened week, only averaging about 760 million shares a day but the heaviest volume came on the days the markets declined.

At first glance, the housing recovery appeared to have a setback as housing starts fell 8.5% in January. Fortunately, after looking into the numbers we still see signs of strength within the industry. Single family home starts actually advanced 0.8% for the month and are back to levels last seen in 2008. Most of the decline was due to the decline in apartment and condominium starts. Low mortgage rates and solid traffic levels of prospective buyers are additional encouraging signs for the housing recovery. Anecdotally, we have heard banks are being careful about flooding the market with foreclosures which also helps the market remain firm.

In the short run, investor enthusiasm seems to be fading. The AAII Bullish Sentiment index shows investors optimism has now declined four straight weeks. Additionally, the Investors Intelligence index shows a similar trend. The percentage of bulls recently fell below 50% for the first time in over six weeks. Historically, we have found when sentiment levels are extreme and start to trend in the other direction, stock prices often reverse.

The public was not the only one to get overly optimistic. Wall Street analysts appear to be bullish as well. Presently, analysts have about 12 buys for every 1 sell, suggesting extreme bullishness. From a contrarian point of view this suggests stocks could be topping. Several other indicators also suggest that stock prices might have run too far too fast. Today, 77% of stocks are trading above their 50 day moving average; levels above 70 are considered overbought. In addition, our risk exposure ratio is at 73%, suggesting that the chance for a pullback in stocks is rising.

Nevertheless, our intermediate indicators remain neutral and our short term indicators are favorable by a 3 to 1 margin. As Barry said on CNBC this last week, “Stocks may be topping, but don’t underestimate how high they might go.” While risk levels have risen, there still seems to be some upside for stocks. We would recommend keeping equity levels where they are, while removing stocks that may no longer be bargains.

Trent Dysert
Barry R. James, CFA, CIC

Bond Market Analysis

Conclusions: Like an aging baseball star, the great bond bull market may be nearing the end of its career, but it occasionally has some pop left in its bat. Last week we saw long term treasuries outperform the rest of the bond market, something rare this year. Treasury yields dropped about 6 basis points, putting longer term yields at the lower end of their recent range. We will soon know if this is an aberration or a return to normal for the once powerful bond market.

Individuals have been abandoning intermediate and longer term bonds at an accelerating pace. Over the last six months money has been moving out of bond funds and into short term and asset allocation funds. It may only be a toe in the water for equity funds, but the Dow has risen 136% from its March ’09 lows and those who had abandoned stocks for less risky assets are finally getting nervous about missing out. Almost every pundit has pronounced the bond market as a bubble that will end terribly. Of course the bond market hardly qualifies as a normal mania.

As we have seen with stocks in 1999 and housing in 2006, manias have specific characteristics. First, the rise in prices is not associated with any economic reality. Second, everyone knows about it and nary a negative word is mentioned. Furthermore, it is widely touted and the average investor knows it is the only place to make money and they are convinced they will be able to exit before things get out of hand. Lastly, anyone who warns against it is panned and disregarded.

Looking at these criteria, we do find 10 year treasury bonds are yielding about the same as the rate of inflation. This is lower than normal, but isn’t that far off of economic normalcy. Individuals had been moving from equity accounts into bonds over the last 4 years, but they have even socked away more in money market accounts. Bonds haven’t been touted for years and they are regularly being panned. They have been a defensive play not one of excessive enthusiasm. As such, we don’t expect rates to suddenly blast off.

Economic reports were muted last week. The Philadelphia Fed report was negative, both Consumer and Producer Prices were in check and housing seemed to cool off a little. In addition, the leading indicators were tame and unemployment claims rose. Our bond indicators remain favorable and we are still near the highest levels for yields this year. While stocks are getting the glory, it is too soon to abandon bonds and they should rebound when the stock market corrects. We would maintain a good position in high quality bonds with extended durations.

Barry R. James, CFA, CIC
Listen Live to our Daily Market Comments at 8:30 am eastern time on http://www.myclassiccountry.com

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