Stock Market Analysis
The rally for stocks continued last week. Larger issues, like those of the S&P 500 gained 0.9% and the small cap Russell 2000 was even more impressive and advanced 2.6%. Leading the charge were the Financial and Energy sectors. Meanwhile, Non-Cyclical and Healthcare issues declined. As one might expect, advancing issues outpaced decliners.
What should be made out of the recent upward stock action? It seems investors are betting on hope. They hope a new direction in Washington will lead to better economic growth and better corporate profits.
Indeed, this hope has caused a seismic shift in investor opinion. According to the American Association of Individual Investors (AAII) bullish investors greatly outnumber bearish ones. This is in stark contrast to just two weeks ago when the bears led the pack.
While hope is good and can push stock prices higher, eventually it needs to be backed by concrete evidence justifying the enthusiasm. Much is being made of potential tax cuts in corporate rates and some are giddy at the thought of repatriation of the trillions of dollars sitting in corporate accounts overseas. The problem is, even if there is broad agreement between the White House and Congress, it can take a maddening amount of time to iron out the details. This uncertainty can cause boardrooms to pause before looking to expand or take other action. Waiting for Washington “proof” may eventually sidetrack the “hope” rally.
We have other concerns. Valuation levels remain historically high. An improving economy and an uptick in earnings may help, but investors should remain guarded against overly optimistic expectations of double-digit returns for the next several years.
With that said, we have found some intriguing reasons for optimism in the intermediate future. The consumer, a giant in the GDP equation, is spending. Retail sales were robust in October. This is particularly true with big ticket items: vehicles, furniture, electronics and building materials. The strong pick up in housing starts is further evidence of consumer spending. Recent reports show new homes are being constructed at their fastest rate since 2007.
Presently our leading intermediate-term stock indicators are favorable and we believe the “hope” rally may continue for a time. In this environment we expect smaller issues to continue to lead their larger brethren. We would maintain a moderate level of equities with a good percentage in smaller issues.
David W. James, CFA
Bond Market Analysis
Bonds tried to stage a mid-week rally but ended the week lower. Long U.S. Treasury bonds and corporate bonds declined about 1 percent while high-yield bonds rose about 1.5%. U.S. Treasury bond yields are now above where they began the year.
The U.S. dollar (USD) index advanced over 2% last week compared to other major currencies. The USD is now at its highest level in over 13 years. In addition to the increase in interest rates, this rise in the USD makes our goods more expensive overseas and could slow U.S. economic activity. A strong dollar also tends to push inflation overseas and keeps it contained here. Both of these could help bonds perform better.
While industrial production was flat during October, manufacturing showed a slight increase. Capacity utilization declined to 75.3%, likely reflecting unseasonably warm weather. U.S. leading indicators were slightly higher last month but the overall picture is still lackluster.
Housing starts rose over 25 percent in October! This is the highest level since August 2007 and the highest monthly increase since 1982. However, last week mortgage applications to purchase a home dropped 6 percent and refinance activity dropped 11 percent. The rapid increase in interest rates has driven the 30 year fixed rate mortgage up to around 4 percent from around 3.5 percent in July.
Retail sales came in better than expected but were still less than the prior month. As our Director of Research, David James, pointed out in our stock analysis, “big ticket” items including vehicles, furniture, electronics, and building materials sold well in October. However, producer prices and consumer prices increased by less than two percent over the last year.
Our indicators have turned neutral and we would take a neutral approach to durations. Nonetheless, tactical shifts will be indicated from time to time to take advantage of overbought and oversold conditions.
Matt Watson, CFA, CPA
