Finance, Insights

Summer Wind

PaulNolte-2Now that wasn’t too painful. May was supposed to be the period that investors take profits off the table and head for the beach to work on their bronze tan. Instead the SP500 made fresh all-time highs with Friday’s close and potentially set the tone for the summer. For its part, the economy continues to plod along, although last week we got another reminder of just how cold the winter months were with a reduction in the GDP for the first quarter. Other data that references the more recent past indicates the economy continues to grow. Friday’s employment report should, based upon the weekly claims figures, be rather positive. In the perverse world of Wall Street, investors may soon become worried that employment maybe getting tighter, which could finally be a good sign for wage growth. Earnings will be on the back shelf for the month, while investor’s shift their focus to global economic reports. In addition to the employment report, Europe Central Bank determines rates as does the Bank of England, Syrian elections and Fed speeches are all on the docket for the week. When hitting the beach, remember the hurricane season also starts. Enjoy the sunshine!

Predictions for the hurricane season are for fewer numbers and a generally quiet season. Similarly, predictions for the SP500 during the summer months are for similar patterns of the first five months. The SP500 has been characterized by relatively low volume, very low volatility and a slight upward bias. Could both predictions be wrong? There are a few clouds on the market’s horizon that should be watched. First is investor sentiment. It has been bullish and getting even more so, rivaling that of the end of the year. One way to look at volatility is how far the markets move from their past six month averages. Last week registered the lowest readings since 2006. The markets are rarely in a steady state for long, so it wouldn’t be surprising to see volatility pick up in the summer heat. With investors all standing on one side of the boat (bullish) it wouldn’t be surprising to see markets head lower in the months ahead. Far from being a bearish “call”, at this point evidence is stacking up for yet another breather for stocks. The economic backdrop remains good, so any correction, if indeed one comes, should be short and shallow variety that has “freckled” the past 18 months.

The bond market remains very strong, as the bond model has been positive for the past half year. Seemingly a long time, this cycle is well within the normal range and still half of the yearlong cycle that marked the ending of the 90s bull market in late 1998. As a result of the decline in long-term yields so far this year, the difference between short and long-term rates is getting smaller. Since short-term rates have been nailed to zero by the Fed, the only “flattening” is as a result of the yield decline in long bonds. The “spread” has been between 2.7% and 4.5% for all of the past six years. If/when/until the Fed begins to allow rates to fluctuate “normally”, that spread is likely to remain abnormally high.

Taking a few big steps away from the daily/weekly minutia of the markets and looking at the big picture, the markets remain well above long-term averages. Although the same may not be said for all the various asset classes, as small stocks continue to struggle after their early year decline. One other worry is that bonds have been holding their own against the SP500 since late November 2013. Whenever bonds begin to best stocks, it is a time to rethink market exposure. For now, it is a yellow flag, but barely so. We have been looking around at other asset classes that may knock the SP500 from the top of the performance pile. One that is interesting is REITs, as they have been used by investors as a bond substitute and have historically moved opposite of the SP500. As investors scramble into utilities and other higher dividend paying stocks, REITs have also drawn some of that interest. Whether this is a sign that investors are moving to the comfort of “safe” stocks and a precursor to a bigger decline in the broader market, only time will tell. But the changes below the surface of the markets indicate a very turbulent market, despite the low “on the surface” volatility.

The coming week is loaded with the “big” economic data as well as comments from international banking officials. Are the global economies strengthening? Does this allow the central banks to continue withdrawing easing measures? Will that strength translate to stock market strength? This week won’t likely answer them all, but the extra data points may indicate the direction that economy is headed and investors will react accordingly.

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.