Analysis: State of the Stock and Bond Markets

October 15, 2012

As stocks fell last week, bond prices increased.  Gains were concentrated in the longer U.S. Treasury issues, especially the 30 year maturity bonds, where yields fell about 14 basis points.  Yields on the ten year U.S. Treasury bond fell about 9 basis points.
-Barry James, CEO, James Investment Research, Inc.

Stock Market Analysis

Conclusions:  The market pulled back with the Dow falling over 2 percent.  Smaller cap stocks fell even more as declining stocks swamped rising stocks by more than a two to one margin.  In addition, every sector fell while defensive stocks, like Utilities, fell the least.  Still, you can tell we are bouncing around the highs for the last year because we still had 294 new highs.  We have had a wonderful rally since early June; perhaps the market is growing a little worried about the earnings season that is upon us.

We appear to have entered another one of those markets we call, “The Twilight Zone.”  This is a time when normal investing doesn’t seem to work like it usually does.  Here are some examples:  Equal sector weights have been underperforming market weighted results.  Through September, the equal weighted index was up 12.76% while the market weighted S&P 500 was up 16.44%.  Furthermore, deep value characteristics haven’t been working at all.  We looked at the cheapest stocks by P/Earnings, P/Book Value, and P/Cash and found that they actually fell in price this year.  The most expensive in these categories did very well.  Lastly, we have found  a limited number of stocks have been driving a lot of the returns in the indexes.  For instance, Apple has accounted for about 20% of the return on the S&P 500.  A broad equal weighted index, the Value Line Index, has underperformed the market weighted, large cap S&P 500 by almost 5% this year.  Lastly, the median stock we follow (>$200 mil) has only had about 1/3 the return of the S&P 500 in the last 12 months. 

None of this means stocks have to fall dramatically, but it gives us pause about joining the crowd.  Perhaps foreshadowing more market woes, the market fell in spite of some pretty good economic news.  The unemployment rate fell to 7.8%, the number of weekly unemployment claims fell to the lowest level in 5 years and Consumer Confidence rebounded strongly.  Those numbers seem a little hard to believe, given the reticence of business to do anything in front of the election.  This last week I found our medical insurance rates will rise 50-75% next year to account for the changes required by the “Affordable Care Act.”  My personal rate went up almost 100% this year as insurance companies are shifting policies in anticipation of losing younger participants.  Furthermore, I heard from my Uncle and he found the “Affordable Care Act” has caused him to lose his Medicare Advantage coverage and will result in an additional $250 a month in costs.  Needless to say, these extra costs will result in fewer dollars for the products and services of many companies.

In spite of all these negatives, our risk indicators are basically neutral in the short and intermediate term.  Our economic outlook is pretty bleak for 2013, but the market may yet have some upside left.  We currently are maintaining a balanced approach to stocks, around 50% for typical accounts.  We do think the next major move will be a correction, but we don’t have the usual signs yet.  We are patiently waiting, which sometimes is the best path to take.

Barry James, CFA, CIC

Bond Market Analysis