Stock Market Analysis
The Dow rose 0.26 percent last week while smaller cap stocks lost 0.17 percent. Losing stocks slightly outpaced advancing stocks, but we still saw about five times as many new highs as new lows. After running hard this year, Utility stocks fell sharply while Energy stocks rebounded with the spike in oil prices. The third quarter was positive for stocks, but most of the advance happened on the heels of the Brexit vote.
The election is a month away and someone will become President, but it is not apparent either side will win. While it may be correlation without causation, Sam Stovall found a rising market between July and October has a track record of pointing to victory for the incumbent party while a falling market has been favorable for the challenger. Currently the market is essentially flat, so October could hold the key. If we can predict October, we can supposedly predict the election.
Barron’s reviewed research on the month of October and found it is typically a down month in election years. While large stocks tend to head bit lower, more speculative stocks felt the brunt of the decline. However, once the pain of the election ends, November and December are typically up months. This may provide sparse solace for those whose preferred candidate loses.
Policies will matter for the future of the economy and the markets. However the options seem to be diminishing. We have tried various methods for reinvigorating our economy using both monetary and fiscal policy. Our nation has borrowed and spent more money in the last ten years than in our entire history. We have had quantitative easing to the tune of trillions of dollars. These have not worked and even revised GDP numbers are far less than the historic 3% growth we would hope to see. The last options would appear to be tax and regulatory changes, but it will be difficult for the new president to make much progress in the face of the divisions created this election cycle.
We continue to see opportunities in smaller stocks. I was on CNBC Asia this past week and noted our research finds that smaller cap stocks historically do very well after lagging larger stocks for an extended period of time. In addition, I pointed out the typical small stock has a lower valuation and a higher earnings momentum than the typical large stock. In the last quarter they have outperformed larger stocks but they still lag them over the last twelve months. Once that hurdle has been crossed we anticipate and extended period of outperformance for them. We have been gradually increasing our exposure to smaller stocks and if history holds in October, we might have an excellent opportunity to increase it further.
We have been treading more cautiously lately but we are seeing some improvement in our risk indicators. After more than forty years of following them, we know they tend to be early. This is a key reason we use a gradual approach to raising or lowering equity levels. They are not yet positive enough to signal a change in our stance, but we are starting to upgrade our list of buy candidates. We may well see stock prices slip in October, but this might be an excellent time to add equities.
Barry R. James. CFA, CIC
Bond Market Analysis
After struggling a bit in the last month, longer term bonds rebounded last week. Long-term Treasury bonds gained as did every sector of the bond market with high yield bonds doing best. In part, U.S. bonds became a haven for investors who were worried about Deutsche Bank. Fears of a Lehman Brothers type contagion made these relatively safe assets the investment of choice.
Deutsche Bank is facing problems of profitability but the legal shoe also dropped this week. The U.S. Justice department is looking for $14 billion to settle its case on mortgage bonds. This would exceed their litigation reserves, but the bank has huge reserves overall. Nonetheless, if uncertainty spreads deeper into its bonds and derivatives markets, ripples will be felt in financial markets.
Economic reports also gave a bit of a boost to bonds. While GDP was revised up a little for the second quarter, it still remains well below satisfactory levels. At the Presidential debate, Lestor Holt talked about the increase in jobs in the last few years. However he did not mention one area the Fed is focused on, the participation rate. What we have seen is job growth running significantly less than the growth in the working age population. This means more and more folks wind up out of the work force. In addition, the Fed Labor Market Conditions Index has again turned negative. It has only had one positive reading this year. In addition, the jobs being generated are far more the lower rather than the higher wage ones.
The Dallas and Richmond Fed reports had negative components and new homes sales slipped in August. Seasonally adjusted home prices were unchanged in the most recent report, but are still up 5% over a year ago. Of course, one of the most important areas for the economy is consumer spending. Consumer confidence is sometimes a predictor for spending and it improved nicely in September. This was true of the University of Michigan Index as well as the Conference Board’s Index.
The final adjustment to the Second Quarter GDP report moved the reading higher by 0.1% to 1.4%. Personal consumption has turned higher, which is usually a good sign. However, other components like business investment, inventories and government spending all fell. A positive for GDP was the improvement in exports over imports, but we’ve often pointed out that rising imports is actually a sign of underlying strength in our economy.
Bonds had pulled back and our indicators had improved. We have used this as an opportunity to pick up longer term high quality bonds. We would continue to do so as needed since our sluggish economy and lack of demand for money leaves room for rates to settle back down again.
Barry R. James, CFA, CIC
