Sinko de Mayo?

PaulNolte-2Will the real economy please stand up? For all the good news on the economy, there continues to be lingering doubt that the economy is really improving. This past week saw the largest monthly gain in non-farm payrolls in just over two years, yet the pessimists would point to those dropping out of the labor force. Wage growth is at the fastest rate in over four years, yet the pessimists would say at 2.3%, it is hardly robust. The Fed sees enough economic strength to continue reducing their bond buying by another $10 billion. The pessimists would point to the weather induced very poor first quarter economic growth of 0.1%. So which is it? Is the economy in jeopardy of falling into a recession or is it actually strong enough to weather the storm? Commercial and industrial loan growth has picked up dramatically since the first of the year, now at the fastest in six years. While never exciting, tax collections have been well above year ago levels, effectively reducing the budget deficit by nearly half over the past three years. A recession, like the next interest rate hike, remains well into the murky future.

A more immediate concern for investors is the dichotomy between the NYSE stocks and those on the OTC market. Historically, the OTC market has been full of technology or small companies that grow much faster than the “stodgy” ones listed on the NYSE. The OTC market has looked terrible since early March, when it began performing much worse than the SP500. Investors with a long memory are pointing to the similarities to the market in 2000, when the OTC market dove well in advance of the SP500, foretelling the disaster that was to follow. However the market internals are very different today than 15 years ago. In 2000, the number of stocks rising was small in comparison to those falling for much of the prior two years. Today that advance-decline line is making new highs. The percentage of stocks making new highs was near a multi-year low a good two years in advance of the peak. Today, that ratio has been in the top quartile for much of the past two years. Without dismissing the divergences as meaningless, they are neither as dramatic, nor as dire as the gloom and doom crowd would have you believe. Yes, the markets can go down from here; however without a recession on the horizon those declines are likely to be relatively mild and quickly recovered.

One other negative investors point to that indicates the weakened state of the economy is the bond market. If the employment report was so strong, why did the bond market rally? Yet, if the Fed pulling away from their bond buying program is bad for bonds, why is the bond market rallying? Could the economy be in a “goldilocks”situation, not too hot, not too cold? Inflation seems to be modest, despite the best Fed efforts to spur it higher. At some point, yields will rise and bond prices will fall, just not yet. Unfortunately for savers, low yields are likely to be with us for longer than many expect. But the seeds of higher inflation are indeed being planted; it will just take some time for germination.

Friday was an interesting day in the markets as bonds rallied, yet defensive groups performed poorly. Small cap did well, yet the OTC market continued to suffer. The 2% drop in the market leading utility sector may be signaling that a change in the markets may be at hand. After going from “worst to first” in the SP500 industry ranking over the past four months, the decline in utilities may indicate the decline in the OTC market may be closer to concluding. Over the past two weeks, as the defensive parts of the markets took a break, the leaders were healthcare, technology and energy stocks. Even the much maligned biotech sector has found a temporary bottom as they have rallied from their mid-April low. Is this just a pause before another leg down? Maybe, but the recent decline has put many of the indicators within the biotech sector to “oversold” territory, where rallies could be expected. In the face of declining prices, the energy sector has performed well. It would help the sector if oil prices were rising, but even as oil prices have moved sideways over the past three years, the stocks have rallied, a potential sign of continued value in the sector.

Many of the indicators that we review do not indicate a recession is on the immediate horizon. To us this means that market declines should continue to be rather short and shallow. For the SP500, a break below the April lows of roughly 1800 could change that short-term picture. Bond investors can “enjoy” low rates for quite some time, as the Fed is indicating increases in short-term rates will be well into the future.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.