Stock & Bond Market Update (2/22-2/26)

Stock Market Analysis

It was a profitable week for stock investors. The large cap stocks of the S&P 500 gained 1.6% while smaller cap issues, such as those of the Russell 2000, returned 2.7%. Furthermore, advancing securities outpaced decliners by better than a 3-to-2 margin. Overall the advance was paced by basic material and cyclical stocks with only the utility sector falling.

The recent rally has been a nice break from the market troubles of January. The S&P 500 is now more than 7% higher than the low it hit in the recent correction. (10% or more drop) In addition, the typical NYSE stock is up almost 8% from its recent bear market low. (20% or more drop) The cumulative advance-decline line has also rebounded. New highs minus new lows are, on average, still negative in February but they improved dramatically from January’s rampage.

What should we make of the rally? Quite a bit actually. Instead of hailing the bounce as a time to “buy the dip,” pundits seem to be almost unanimous in proclaiming sell on any advance. Zerohedge even asked, “[Is this] the most hated dead cat bounce ever?” Bank of America’s Chief Investment Strategist Michael Hartnett certainly seems to think so. This week he noted “Everyone (including ourselves) [is] a ‘seller into strength’...” The surveys confirm this pessimism. Both the American Association of Independent Investors (AAII) and Investor’s Intelligence (II) have more bears than bulls.

For contrarians this is good news. In his seminal work on contrary thinking, Humphrey Bancroft Neill suggested, “When everyone thinks alike, everyone is likely to be wrong.” Although this idea was espoused in 1954, it is still true today. Given the intense distrust of the recent rally, it is likely stocks will continue climbing this wall of worry.

That is not to suggest the market is ready for a new bull market. Presently 96% of S&P 500 companies have announced their latest earning’s report. The numbers are sobering. Most companies have not only experienced declining earnings but falling revenues as well. Many retailers including Wal-Mart, Sears, Target and Best Buy are closing stores.

Some are heralding the better-than-expected personal income and spending numbers. However disposable income has only grown by 4% in the last year and spending has advanced 4.2%. Both numbers are a far cry from their historic averages of over 6.5% growth. Put simply, the United States in not operating on all cylinders.

While our indicators are positive overall, some of our most accurate intermediate indicators still suggest caution. Pessimism is rampant and limited buying of equities may be in order where appropriate. We recommend favoring value securities which are now showing leadership qualities.

David W. James, CFA

Bond Market Analysis

Yields rose for most bonds last week as prices fell. In part, this was a natural reaction to the strong equity advance. Stocks once again attracted the attention of investors. Economic events also played a part among bond investor decisions.

The Philadelphia Federal Reserve Manufacturing Index reported, for the sixth consecutive month, a negative reading (-2.8). The factory outlook weakened in response to lower consumer demand. Year-end retail sales were a disappointment but not a disaster for most stores. Select high-end stores, such as Nordstrom, were especially hurt by cutbacks among the wealthy. Previously, FED stimulus helped propel sales in this demographic. However, it is not only luxury stores seeing weakness. Wal-Mart has slowing retail sales and the company projected a relatively flat 2016 as compared to 2015.

At the end of January, real (after inflation) 30-Year U.S. Treasury yields were near 2.0%, today about 1.25%. Powerful forces have been at work in moving these bonds, considering the size of the market. We believe the relative safety of U.S. obligations may have played a significant part in the support the market has received. One should also include reactions to commodity downturns, especially the pricing of copper and petroleum. Fears about commodity related bonds helped move investors toward Treasury bonds.

What else has been helping bonds this year? First, worry over some national credit instruments, such as certain sector bonds in the Chinese market. Second, we have seen some signs of slowing growth inside the U.S. For instance, tax withholdings have weakened and Trim Tabs reports, “The deceleration really started back last autumn.” According to Investors’ Business Daily, U.S. tax withholdings have been known to signal job weakness in advance of other official data.

On a technical basis, the stochastic on the 10-Year Treasury bond continues to fall. We do not look for a smooth path for bonds. They have recently been tethered to stocks, moving in opposite directions. If we do see stocks swoon again, we believe bond prices should rally.

Right now our bond indicators are neutral to slightly unfavorable. Until they turn favorable, we would hold modest positions of higher quality bonds with moderate durations. We would favor a barbell strategy, a portfolio that includes long term bonds as well as shorter issues. We would continue to look for opportunities in inflation adjusted TIPS bonds. Lastly, we expect any correction in interest rates to turn into buying opportunity for high quality bonds.

F James, Ph.D.

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