There is something rotten in Denmark…and it is not the lutefisk! The release of the Fed minutes mid-week indicated they were very prepared to increase rates at their December meeting, barring of course any global problems. The markets rallied strongly upon the release, as if to breathe a sigh of relief that the path higher for rates will be gradual as economic conditions are not “overheated”. If the economy were cooking along, the rate hikes would be coming much quicker and the path of increases steeper. The economic data that most supports their position is employment, now at very low levels and some incipient signs of wage growth. However that wage growth, as of yet, has not translated into inflation as producer and consumer prices are well below Fed targets. Commodity prices continue their slide to multi-year lows, a nod to the lack of global demand and still weak global growth. The process of making lutefisk uses deadly lye, let’s hope the process to a “healthy” economy is a bit more savory.
What is stinking is not the pungent smell of lye, but the lack of participation in the push higher for stocks. Even as the averages rise, fewer stocks are participating in the rally. Five stocks within the SP500 have a weighted gain of nearly 3.5%, meaning the remaining 495 stocks are down an average of 2.25% on the year. Put another way, investing outside of a very narrow group of stocks has meant missing the benchmark return. The furious October rally to just below the peak saw less than half of the stocks within the index participate. These five stocks averaged over 15% returns, twice that of the index during October. When looking at the net number of advancing to declining stocks within the SP500 plotted over the year, it has the shape of an inverted bowl. So while the “average” is very close to all-time highs, the average stock remains well below its own “all-time” high and long-term average price. So the erosion below the surface we described earlier this year has continued and is beginning to show up in many more places, indicating a more blue than green Christmas.
Interest rates moved in an interesting fashion last week as well. Short-term rates rose slightly, but longer dated maturities actually rose in price as yields fell. Investors believe that the “pre-emptive” rate increase is likely to keep inflation down, allowing long-term rates to stay low. Discussions around the web highlight the likely increase in inflation as we begin lapping low energy prices. Crude oil prices were $75/bbl a year ago before dropping to $55 by January this year. The impact on overall inflation from the drop from $55 is much small than from $75, so a big negative is removed from the inflation calculation if crude stays around $45. What has been missing from this argument has been the decline in other prices. From cattle to cotton to lumber, prices of commodities are all falling. It is the argument of the Fed to begin raising
rates before the inflation “genie” gets out of the bottle. Based upon today’s prices the bottle remains buried in the desert. Highlighted above has been the “problem” for money managers of all stripes, whether running a mutual fund or holding diversified assets. The SP500 has been dominated by a few holdings that have skewed performance of the popular average. Small stocks remain lower on the year, mid-cap stocks are essentially flat and while the SP500 is higher, the top 100 stocks are up nearly 5% for the year. International has been hurt by the stronger dollar while emerging markets are lower by roughly 10%. Since roughly mid-2014, the SP500 has been consistently the only game in town and the larger the stock, the better the performance. The reaction of the markets to a Fed hike indicated everyone wins, however as we saw
over the past seven years, a zero rate environment had clear winners and losers. Since economic growth is not picking up, the rate increase is not likely to benefit stock holders as investors assumed by bidding the markets higher.
Thanksgiving week kicks off the Christmas season. Historically the strongest period of the year, the last time the markets fell during December was in 2007 with a modest decline. While this year is not likely to be very different from historical norms, warning flags are beginning to fly that 2016 may be a rougher year than even the eventfully unchanged markets this year. Bond investors may be among the investment winners next year, even though rates are expected to rise. Those expectations may change rather quickly once we begin the next year.
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.