Long Train Running
When looking at a map (for those that still do!) to find a good way from here to there, the further to two points, the more and varied the possible routes. From the direct to the scenic, from stops along the interstate to winding roads in the back woods to find a hidden gem, each traveler has their favorite way to go. So it has been with the markets over the past two years, encompassing the “hurry up and get there” of 2013 to the long and winding road to nowhere of 2014. Investors, the back seat drivers of the trip, are urging the markets to get a move on. Investors want to see the returns of last year and are very frustrated with the circles the markets have been going in this year. The economy doesn’t seem to be providing much navigation, as every release seems to contradict the prior release. Yet, when looking over even just the past six months, the economy continues moving forward, of only at snail’s pace. There is enough evidence of growth to keep the Fed tapering, yet not fast enough for them to raise rates. Corporations are trying to mollify the finicky investor by doing anything, from buying back stock to raising dividends to buying other companies. What a long, strange trip it’s been.
Many try to use old maps to help them discern where they are today, by comparing it to something in the past. For example, pundits are pointing to the weakness in the OTC market as similar to that of ‘99/2000. However, so much is different within the market today than at that time. For example, in ’99 the market internals were looking poor, as many more stocks were falling than rising. Even though the SP500 did not begin falling until late in 2000, much of the market was already declining. Valuations today, while high, are nowhere nearly as high as the records set in that period. Finally, the Fed remains very accommodative, whereas then they had begun a tightening cycle. While an old map may still have many of the features of the current landscape, much has changed. The decline in small stocks has now put that market below its long-term trend for the first time in 18 months. While the remaining six asset classes are well above their trends, this drop by small stocks is not a great concern. Until there is more deterioration, stocks can continue to meander higher in the weeks and months ahead. Interestingly it may be the bond market that ultimately provides a “signal” to move out of stocks. Once bonds begin significantly beating stocks, it is time to exit. Bonds have merely pulled even so far this year.
The bond market continues to surprise as returns have erased all of last year’s losses. Not only are bonds doing well, but the bond like instruments like utilities and REITs are also performing well. The Fed is reducing their bond purchasing, which is supposed to push up yields. But then the various QE policies were also supposed to spur inflation to incredible heights. The map that many are using does not include a highly leveraged economy that we have not seen in the US before. The twist is the Fed is trying to encourage inflation, unlike their policies of the past forty years. At some point, they will likely be successful, but it may not be this year.
For every break in the market or decline lasting more than a week, analysts are quick to jump on the “correction” or “big decline” bandwagon. But as outlined above, the markets don’t seem to be moving to the historical “maps”. There are plenty of crosscurrents in the markets. Industrial stocks and utilities are the leading market sectors this year. The momentum stocks have lost it, while international is making a comeback. One sign that the overall market remains generally healthy is that more stocks are rising than falling. This can best be seen when comparing the SP500 to and“equal weight” index. The SP500 is capitalized weighted, meaning the largest stocks have the greatest weight. An equal weight flattens that relationship, making all members of the index equally weighted. The performance of the equal weight funds is very close to that of the SP500, meaning smaller stocks within the index are doing just fine thank you! When that performance begins to widen, it will be a sign that just the very large stocks are propelling the index without the participation of the rest of the troops. That will be a sign that the risks have increased.
For all the hand-wringing of impending doom since the OTC market has fallen, the markets remain on relatively strong footing and can be bought even at new highs. When bonds begin leading the charge and fewer stocks are participating, it will be time to reduce equity weights. For now, even bond investors can feel comfortable holding onto positions, until inflationary pressure begin to rise, which have yet to occur.
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.