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Analysis: State of the Stock and Bond Markets

September 24, 2012

How do we get more jobs? One method is to lower the regulatory burden. Some regulations are needed for our country to run effectively. Unfortunately, Washington has left common sense far behind.
-David W. James, senior vice president, James Investment Research, Inc.& Dr. Frank James ,Founder, James Investment Research, Inc.

Stock Market Analysis

Conclusions: After two weeks of gains the market had a small sell-off last week. Indeed the old saw of "Buy on the rumor and sell on the fact" seems to have fit the script for the FED's latest foray into quantitative easing. Large stocks fell 0.4% and smaller issues declined 1%.

Indeed, all of the usual suspects from QE programs of the past had a reversal of fortune. Oil had a dramatic 6.5% decline, the dollar strengthened versus the Euro, long term Treasury bonds advanced and TIPS (Treasury Inflation Protected Securities) fell. The world of expectations simply pulled away in reverse.

What is next? There are some positives. Retail sales are rising. Admittedly prices at the gas pump count for an uncomfortable level of the retail sales gains, but there is still growth in big ticket items such as building materials that offer some encouragement.

Likewise there is encouraging news in the housing market. One of the biggest problems has been the oversupply of homes. At first glance, the growth in housing starts last month would seem to be anything but encouraging to the supply problem. However a closer examination of the data shows single-family units starts did not grow but actually fell by 6.5%. Couple this with the National Association of Home Builders (NAHB) report showing a growing number of prospective buyers are examining available homes and there is a guarded sense of optimism.

Unfortunately there are rampant economic problems that could create difficulties for stocks. The inflation differential between wholesale and retail inflation has shifted course and now suggests difficult times for profits. Likewise the four horsemen of the economic apocalypse, the FED reports from Chicago, New York, Philadelphia, and Virginia, are all negative. Historically this is associated with a 60% occurrence of an economic contraction ahead.

Further, employment continues to be abysmal. The Bureau of Labor Statistics reports a record 88.9 million American are not in the labor force. On top of this almost 8.8 million Americans are now of the federal disability program; a dubious and expensive record.

How do we get more jobs? One method is to lower the regulatory burden. Some regulations are needed for our country to run effectively. Unfortunately, Washington has left common sense far behind. The new health care law takes 18 pages to simply define what a full-time employee is. It may be that those in power do have common sense but, unfortunately, they seem to ignore it. According to Gallup it is the threat of new regulations that give so many small businesses pause when considering hiring workers.

Today our leading indicators, while improving, are still suggesting elevated risk levels. In this environment it makes sense to avoid an aggressive equity posture and continue to favor bargain stocks.

David W. James, CFA

Bond Market Analysis

Conclusions: Last week equity markets underperformed, only defensive sectors moved higher, including staples, health care, and telecommunication services. On average, commodity prices fell by 3 to 4 percent, however crude oil lost 6%. Bond investors enjoyed a better week. Markets reflected the FED's Operation Twist as yields out to 3 years held firm or rose slightly while the 5 year treasury yields lost 4 basis points, the 10 year bond yields fell by 11 basis points and the long 30 year bonds lost 14 basis points. Mortgage bond yields also fell, the 15 year fixed rate bonds closed at 2.77%.

It is interesting to note equities in sectors such as finance, energy, and technology have done best over the past three months, a tribute to their ability to pass along disruptions in the markets and currency flow. Finance stocks have traditionally done well in offsetting devaluations and inflation.

It may be significant that only 11% of professional investors (CFAs) believe the new Quantitative Easing (QE3) will boost jobs and the housing market. It is easy to understand their skepticism; the FED has already increased the size of its balance sheet from nearly $850 billion in 2009 to $2.9 trillion at present with few signs so far of a miraculous recovery. We foretold the likelihood that FED stimulus would be ineffective in our January 2008 study, "No Quick Fix" The new QE3 will print $480 billion in new money each year, buying mortgage-backed securities. The survey of professional investors (CFAs), 40% believe the actions will stimulate inflation. Recently the government has been overspending each year about $1 trillion. Now the Federal Reserve will manufacture about $1/2 trillion to add to this total.