Stock Market Analysis
New highs for the S&P 500. The Dow rose 1.35 percent last week while the small cap Russell 2000 rose 1.1 percent. The breadth numbers back this up with almost twice as many stocks rising as falling. Also, almost four times as many stocks hit new highs as new lows.
Why does the market continue to advance? I was on a national conference call with two other money managers last week and they had reasonable explanations. One mentioned the three legs which supported the market - valuation, the economy and sentiment. He stated current valuations were slightly elevated but were still reasonable, especially with interest rates so low. He also said according to the Leading Economic Indicators the economy was nowhere near going into a recession. Lastly, he was encouraged by the number of people asking the same worrisome question, “How much higher can the market go?” Neither of the two managers was overly bullish, but at worst they thought the market advance would slow but not collapse.
It is true; some nervousness about the market exists. However, greed has been raising its ugly head and this causes us some concern. We know two very conservative investors who have made recent changes to very aggressive, risky investments. Both are retired and this is all the money they have. One was told they could make 15% annually and the other moved into highly aggressive alternative investments.
Unfortunately, this is reminiscent of 1999. Too many investors had seen the internet phenomenon make a number of folks extremely wealthy. They thought they could move all their funds into one new internet stock and quickly triple their portfolio. No matter how much advice they heard against doing this, they went ahead. Unfortunately they lost everything, a difficult position for someone at retirement age. The age old truism, “If everyone has discovered a good deal it is too late” held true again.
Measuring market risk is an exercise of connecting the dots. It is much easier if you take a few steps back to get a broader picture. This means taking a longer view of risk rather than one of trying to time the market. In this scenario we find quite a few dots connected. Long range valuation methods point to market struggles in the next five years or so. Second, the Federal Reserve has raised rates, suspended Quantitative Easing and are looking to reduce some of the $4.5 trillion it has in assets. Third, sentiment, as measured by market forecasts has a new watchword – Dow 40,000. Our research shows three times as many negative as positive sentiment indicators. Also, the massive and accelerating move into passive investments (now over one third of all equity holdings) is unprecedented and a sign of investor acceptance of a forever bull; a disquieting sign.
Lastly, and not insignificantly, the market is behaving as erratic as an intoxicated driver. Our research shows low quality, expensive stocks have been vastly outperforming bargain stocks over the last 16 months. In fact, in the March to March period, stocks with negative earnings beat those with earnings by over 16%. Also, the market continues to reward a narrow band of very large technology stocks which are producing an outsized portion of the S&P 500’s gains. We have heard tales of new investors doubling their money in two years by investing in stocks like Google, Facebook, and Amazon which sport expensive PE ratios of 33.6, 40.2, and 186.9, respectively.
Markets can and do go through periods of time which do not match up with common sense or historical patterns. They typically go longer and further than comfortable for those who follow a disciplined bargain approach. However, it is often precisely when a common sense approach has been out of the market’s favor for an extended period that investors should ADD money to that style.
Likely, we are close to this point. We remember the late 1990’s all too vividly. No matter the pressure, we believe preserving capital is more important than switching to the latest fad. Our research of the last five years confirms this, even if it has not been apparent in the last 16 months.
Our indicators are not positive and this is not a time to be overly aggressive toward stocks. The Hope rally is long in tooth and results in Washington seem muted. We would use the current rally to trim stocks where appropriate.
Barry R. James, CFA,CIC
Bond Market Analysis
Bonds took the week off with little action except in High Yield bonds. All the other sectors were essentially flat. The Ten-Year Treasury yield remains near 2.25 percent which is up from 1.75 percent six months ago, but down from almost 2.5 percent just three months ago. Rates have risen but the path has been erratic.
This year bonds have quietly advanced with High Yield bonds up 4.7% while other bonds advanced 1 to 4 percent. Most of this had been a rebound after the sharp sell off last year. Foreign bonds have been doing better on a dollar adjusted basis, especially in Germany and the United Kingdom. Most of this advance has been because of dollar weakness rather than falling rates abroad. In fact, both Germany and the United Kingdom have much lower rates than in the United States.
Housing often has an impact on the economy and bonds. Traffic numbers remain high, usually a precursor to higher prices. Indeed FHFA’s Home Price Index rose 6.2% in the last year. Home building has been picking up, but home sales slumped 11.4% in April. Of course, mortgage rates have risen which could be putting a damper on sales. First quarter GDP got an upgrade from 0.7% to 1.2%. However, after rebounding in February and March, durable goods orders slipped in April. These mixed messages are holding the bond market hostage, neither rising nor falling much lately.
The Federal Reserve’s May meeting minutes implies another rate hike may be coming soon, i.e. in June. They also indicated they are nearing consensus on an approach to cut back on its $4.5 trillion in bonds. It is looking at doing this gradually, maybe just letting the bonds mature without replacing them. These moves may seem offsetting, raising short term rates may dampen the economy and help bonds while cutting back on bond holdings may hurt bonds. Washington has a knack for mixed messages and this one will keep investors on their toes.
Our bond indicators are fairly neutral and rates will likely be affected by the Fed and other outside influences rather than significant changes in the economy. In this environment investors should not ignore holding bonds in their portfolio as they continue to offer good diversification from the stock market. However, it is not the time to be overly aggressive and hold a large number of long-term bonds. Maintaining a moderate position in higher quality bonds is prudent.
Barry R. James, CFA, CIC
