The Beginning of Fall
“The more they get, the more they need and every time they get harder and harder to please” (Kinks). From the Fed announcement on keeping rates stable to Yellen’s press conference, the Fed did its best “to give the people what they want.” Rates will be low for the foreseeable future; however we are beginning to get a sense that future is likely in the first half of 2015. Once the cycle of rate hikes begins, it will also be likely at a gradual pace. However, inflation remains very low and employment remains nowhere near what the Fed would like to see, so the Fed remains data dependent. Better, stronger data means the first rate hike is sooner. A turn for the worse and rates stay put. Is it little wonder that stocks were unchanged from Wednesday morning (before the Fed meeting) to Friday’s close? The bond market remains confused as well, as short-term rates are rising and long-term rates are falling. This week some of the Fed governors will be making speeches about the economic outlook and monetary policy. In addition, the European central bank chief Mario Draghi will also be discussing European monetary policy. The transition to fall may be more colorful than usual.
The changing of the seasons also sometimes marks the changing of the markets. The summer rally gives way to a fall correction. A bottoming process during the winter precedes the spring growth. The very large cap stocks, as measured by the Dow and SP500 are doing just fine thank you, however below the surface we are beginning to see signs of erosion. The small cap stocks have been performing much worse than the SP500 since March, international markets and commodities since April. Long-term bonds have actually bested the stocks market this year as investors continue to fret about geo-political concerns. The market internals are also seeing some weakness, as the average SP500 stock is now down 7% from their recent peak price. So even within the large cap index (SP500) there is a great performance disparity between the largest and the smallest. This is not a death knell for stocks, but it may also point to a longer period of frustrating stock price movement. The good news…there have been four other periods since 1979 that are similar to today and the following year (save for 2008) has been a very good year for both large and small stocks alike.
The bond market has become bifurcated, with short-term rates moving higher (and prices lower) and long-term rates falling (and prices rising). Why the dichotomy? The short end of the curve is much more controlled by monetary policy and Fed actions. The long-term is more affected by inflation expectations. The short end is expecting that the Fed will raise rates in the relatively near future and has begun to price that into the markets. The two-year Treasury yield has increased in each of the past five weeks as yields have increased to 0.573% from 0.44%. The lower commodity prices and inflationary reports have been favorable on the long-term bonds as those yields have declined from 3.61% to 3.30% over the past six months.
The anticipated increase in interest rates continues to pressure the more interest rate sensitive parts of the markets: REITs and utilities. Energy, one of the worst performing sectors this quarter, has suffered as prices have declined over the past three months. This is after energy stocks were the best performing in the first half of the year. The rotation has been toward the consumer cyclical parts of the market that is dependent upon consumer spending. Retailers like Kohl’s (KSS) and JC Penney (JCP) have bounced back after a long period of poor relative performance. Other parts of the market thatare sensitive to economic growth like rails and some trucking companies have performed well. The huge initial public offering of Alibaba on Friday took some of the wind from the sails of the technology sector, which has been one of the dominant sectors since May. Many believe investors recently sold technology names to make room for Alibaba in their portfolios over the last two weeks, accounting for the recent technology decline.
The larger the stock, the better has been the performance. International holdings have hurt overall portfolio performance for much of the year, however it has provided good relative performance when the US markets decline. The bond market has been a good overall investment this year, with returns close to those in the equity markets. The divergent performance between the various asset classes will need to be watched closely as either a lead in for an SP500 correction or merely a pause before another leg higher in the broad markets.
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.