Stock Market Analysis
Stocks broke badly this last week, with the Dow Jones Industrials losing about 2.2%, transportation stocks 3.7%, the S&P 500 2.2% and small-cap stocks fell even more. The tech heavy NASDAQ declined about 3.4%. The severity of the loss was noteworthy, with daily volume on Thursday and Friday running above 5 billion shares. One Merrill Lynch analyst ventured that the break was caused by client liquidation of hybrid funds which were invested in large and illiquid securities.
Stocks weren’t the only investments falling last week with commodities plummeting. The CRB Index lost about 5.1% and now has a loss of about 27% for the past year!
The break in U.S. stock prices has been accompanied with a negative break breadth of the market. Are there solid factors behind the break in prices? Internal to the United States, we can find only a few factors justifying the extent of the negative move. The first would be declines in industrial production which have slipped into the negative column. There are of course strong correlations between changes in industrial production and GDP. The second would be declines in retail sales among certain vendors. Macy’s, for example, and Walmart, have announced layoffs and closings of stores based on disappointing sales. Again, we note the strong role of consumer spending in the U.S. economy, said to be on the order of 70% of GDP.
As mentioned in our Economic Outlook, China has been having an outsized influence on our stock market. We saw this in the third quarter, when our market seemed to fall in sympathy with the Chinese market. This is a major change from the small multi-billion dollar economy when President Nixon visited in 1972 to a $10 trillion economy today. It now exports to the world at about the same dollar level as the U.S. Unfortunately, prices on the Chinese exchanges have displayed unusual volatility. For example, the Shanghai Exchange Index rose approximately 2000 points to 5,166 but shortly thereafter fell to the 3,000 level in the late summer. We do not know that such moves have a great deal of long term significance. We’ve seen their volatility pick up again as their market has fallen over 17% this year. It appears that fearing the worst, U.S. investors have followed suit.
The good news, U.S. sentiment figures are getting more positive for stocks. Fear is in the air and according to IBD, the volume of trading in puts is a third larger than that of calls. Bears now outnumber Bulls by roughly 3 to 1 as reported by AAII (American Association of Independent Investors). The Investors’ Intelligence survey also shows more bears than bulls. All of these are bullish signs.
Might the selling be overdone? The 10-day moving average of advances divided by advances plus declines is now well below the 35% figure which traditionally defines the market as oversold and previewing a quick rally. Among the S&P stocks, only 10% are above their 50-day moving averages, according to TCS/Griess, another statistic in oversold territory. Fewer than 20% are above their 200 day moving average, another deeply oversold statistic. However the short term momentum indicator, stock stochastic, hasn’t yet rebounded.
If it were not for the threat of erratic Chinese market swings, we would be even more optimistic, noting bullish signals from McMillan’s equity-only put/call ratio, heavy insider (corporate officers and directors) buying, excessive selling by professional analysts, and increasing margin debt.
From our vantage point, we are optimistic, not pessimistic for stocks this year. We expect domestic economic activity will likely slow, and some global concern is appropriate. Debt in developing countries was undertaken, in many cases, for capital investments to meet the needs of a rapidly growing China. Debt is said to approach 200% of GDP in some of these developing countries. When the economy of a $10 trillion trading nation slows, it impacts countries and markets throughout the world, including the United States.
Markets can move to extremes too rapidly, at such times they tend to reverse and retrace. Sentiment for stocks is too negative and therefore favorable. In today’s environment precious metal issues have appeal, especially those completing long declines. Our leading stock indicators are positive. The Risk Exposure Ratio is only 20%. We continue to believe there is a very low likelihood of a setback rivaling 2008. Those who might wish to lower volatility should practice careful timing. Equity reductions, if needed, are best undertaken as stocks rally. One last positive thought: we believe value investing should dominate growth investments this year, perhaps very shortly, and value stocks tend to resist declines.
F James, Ph.D.
Bond Market Analysis
As bad as the New Year has been for stocks it has been quite profitable for high quality bonds. Long-term Treasuries have advanced 3.8% on a total-return basis. Meanwhile low quality bonds, such as high-yield issues, are down 2.8% over the same time.
Bonds often react to strong movements in the economy. Historically a weak economy often brings a shine to bond investments. To that end we take a closer look at the economy.
Presently the economic news is poor. Consider Industrial Production. Previous research suggests a strong correlation between it and GDP. So much so that since 1940 whenever Industrial Production has fallen (on a year-over-year basis) by at least 1.5% a recession has formed. The current reading is -1.75%
This has been backed up by data in the freight industry. Earlier this week Superstation 95 made this eye raising announcement, “For the first time in known history, not one cargo ship is in-transit in the North Atlantic between Europe and North America... NOTHING is moving... It is a horrific sign; proof that commerce is literally stopped.” If true, we may expect more troubles ahead. These woes are not confined simply to cargo ships. The combination of freight traveling by road, rail, barge and pipelines are declining compared to a year ago.
Some may contend the U.S. economy is now more focused on services and the consumer and that the industrial sector has lost some of its importance. Perhaps this is true. Still, is the consumer rallying the economy?
Bloomberg News reports, “Sales at U.S. retailers declined in December to wrap the weakest year since 2009, raising concern about the momentum in consumer spending heading into 2016.” The data is so bad Walmart, the world’s largest retail store, has announced plans to close almost 270 stores.
Another disquieting statistic is the decline in business sales. When companies are able to sell fewer products, the uncomfortable question arises about how to cut costs, usually in the form of layoffs. Historically, employment levels typically fall when business sales decline.
Taken all together, the signs suggest the U.S. is in recession-like conditions. This is true regardless of what official term is eventually used. Some bond investors believe it may not matter as the lowest bond yields can go is 0%. This may not be true. We have already seen negative rates overseas. In addition, New York Federal Reserve President Dudley announced this week, “If the economy weakened, we would consider negative interest rates.”
We believe it is likely 2016 will be a good year for bonds. Still, no investment goes straight up or down. Interest rates have dropped dramatically in short fashion as former stock investors have stampeded into bonds. A short term correction to this in the form of somewhat higher rates would not be surprising. Indeed, we note our leading bond indicators have gone from favorable to a more neutral configuration. We expect any correction in interest rates would likely be a buying opportunity for high quality bonds.
David W. James, CFA
