Market Perspective for May 22nd, 2015
- Recently, both the S&P 500 and Dow Industrial Averages again closed at all-time highs and are up 4.3% and 3.3% respectively. The Nasdaq made its high late last month and is sitting just below it now. It is up 7.3% on the year. Certain economically sensitive industries have improved recently, notably materials, packaging, and industrial products. The market is conveying the message that the economy is picking up. This is underscored by the steepening of the yield curve so far this quarter. See Figure 1.
- Just a rough quarter for bonds so far. Bonds didn’t provide a lot of return potential at the beginning of the year, and even less so after growth related concerns saw investors shift even more money from stocks to bonds in the first quarter. I don’t know if it was the comments by bond managers Bill Gross and Jeffrey Gundlach in late April to the extent that German bonds were the “short of the century” or not, but bond yields have sharply backed up in recent weeks. With oil prices in sharp decline from last September into this past March, inflation numbers were very weak. Oil has rebounded to just north of $60, suggesting future inflation readings will not be so benign. In any event, sentiment in the bond market has turned around 180 degrees, with bond outflows now returning to the global stock market.
- If I am right about points 1 and 2 above, I believe the Federal Reserve will raise rates in September. Their decision is easier now that the dollar has come off its highs and has clearly lost momentum. They were concerned about a rate hike putting additional pressure on currency markets. Certain countries were struggling with dollar denominated debt and currency flight earlier, but those concerns have abated recently.
- High yield bonds provided a modest window for accumulation earlier this year, but that window is rapidly closing. BB yield spread over Treasuries bottomed at 2.56% in June of 2014 before the energy related second half sell-off. By March 18th the spread had widened to 3.32%. It has come in considerably since. Today it stands at 2.97%.
- Asia has taken over from Europe as investors’ favorite region. Better economic performance in Japan is part of the story, but a bigger part is the belief that China is going to open up its currency market sometime in the next year, which would mean a much higher weighting in international stock indices. Some are front-running the idea that indices are 9% underweight the amount of Chinese stocks they would have if they were included in the capitalization weighting.
Trying to step back and look at the big picture, I think you can break bull markets into three phases:
- In this phase stocks recover in aggregate what they lost in the bear market. This phase is paced by those stocks that lost the most in the bear market EXCEPT those in the leadership group during the previous cycle. Technology stocks were routed in the 2000-02 bear market and financials were crushed in the 2007-09 bear market, and they lagged the next bull market. That said, stocks with weaker balance sheets that fell further in the bear market had a greater response to sharply lower interest rates and greater liquidity.
- In this phase investors step back and appreciate the fact that the market has recovered to new highs and that stocks are no longer cheap. There is often a mid-cycle lull that convinces many that the bull is ending. This phase is led by higher yielding defensive stocks like utilities, real estate, and consumer staples AND whatever industry has emerged this cycle as the secular leader. This time it is health care and biotechnology.
- In this phase investors grow tired of cries of “wolf” and they pursue return with a vengeance. Investors often feel they have underperformed the market because they were too fixated on risk. By this point, money market rates typically do not provide any inflation adjusted return and safer, higher quality bonds are feeling interest rate pressures. Conservative stocks aren’t doing anything either. Whether they realize it or not, performance chasing investors are being herded into an ever narrowing group of stocks that drive an increasing degree of the performance. Some do realize it, but cannot resist the pressure. In the immortal words of then-Citigroup Chairman Chuck Prince in 2007 “As long as the music is playing, you’ve got to get up and dance”.
If this is true, we probably have several months (if not a year or two) left to party. We may have entered the excess phase (and valuations are certainly rich), but there isn’t much real exuberance out there yet.
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 Source: YCharts.com as of 10:10CT 5/21/15
 IVV tracks the S&P 500, DIA tracks the Dow Jones Industrial Average and QQQ tracks the Nasdaq composite.
 New York Times, 07/10/2007 (according to Wikipedia)