Market Perspective for July 6th, 2015

1. How seriously should we take the notion of a strengthening economy when commodities prices fell 3.8% in the first half of 2015? Last Thursday’s unemployment report with its downward revision to previous months and no increase in average hourly earnings furthers the notion that while the economy is growing, it just isn’t that strong.

2. Despite this, bonds are a tough place to be right now. For the past three months bonds have been losing more on reports of economic strength than they gain when the economy appears soft.  High yield corporate bonds are also declining because participants know the next rollover cycle promises to be a lot more difficult.  Developed foreign bonds are rebounding from absurdly low yields.  Emerging market debt is being hurt by fears of capital flight when the Fed hikes.  In absolute terms, emerging market debt is the only bond category that is inexpensive.  It is hard not to feel that bond investors should be underweight across the board.  It would be a mistake, however, to underweight only duration and assume you are safe in lower quality short durations.

3. Technically the U.S. stock[i] market has taken strike one by falling below its 50 day moving average (orange line) and appears ready to take strike two by flirting with the 200 day moving average (red line). See Figure 1.  Even if that happens, investors would do well to remember how good of a two-strike hitter this market has been.  The chart of October, 2014 should be a good reminder.  Stocks rose more than 15% from their October 15^th lows by the end of February.  That said, there are several factors that suggest the market is not as internally healthy as it was last autumn.  We continue to monitor Dow Utilities and Transports, as well overall breadth for signs of continuing deterioration.

Figure 1

4. The most difficult thing about investing near bull market peaks is that the final stage is usually driven by more questionable stocks like Facebook (84 times earnings), Tesla (not currently profitable), Amazon (also not profitable), and Netflix (171 times earnings). I’m not arguing that these aren’t good companies, but they are trading based on assumptions about the ultimate profitability of business models that have no precedent.  Companies like Honeywell, Cisco Systems or PepsiCo, which have well-established business models have hit their P/E ceilings in the upper teens and their prices have more or less stalled out.  In many ways, investing is a “bird in the hand” (safety) versus “two in the bush” (opportunity) proposition; you just have to assess your likelihood of getting the two.  If the “bush” is metaphorically on a peak in the Andes, I’ll take the one in the hand.

5. Rob Arnott published an interesting analysis of factor investing recently. Among his insights:

• New “factors” are being discovered these days through vast numbers of tests (data mining). If you discovered, for example, that midcap stocks had a strong tendency to outperform on the fourth Thursday of the month, would you actually try to build a strategy around it?  Increasingly, ETF companies are.

• The value premium does exist, but largely because value investors try to time the market. By selling as value goes out of favor and buying when it appears to be returning to favor, value investors are actually supplying the alpha to those that do not trade.

6. Greece has voted “No” and the world is still trying to figure out what that actually means. Everyone is in a tough spot.  The Greeks don’t know if they are going to have a banking system at the end of the week.  The Germans fear that Greece will pull out and six months from now their economy will have stabilized and start to benefit from a very cheap drachma.  That would put a lot of pressure on Italy, Spain, and Portugal which would likely bring about the end of the monetary union. In the short run I would avoid trading on this news.  Knee jerk is for stocks to fall and the dollar and U.S. Treasuries to rise.  Then stocks might recover just as they have anytime over the last three years when bad news has come out of Greece.  As noted above, however, there could be wide reaching repercussions of what happens over the next few days.  Considering how expensive stocks and bond are anyways, my vote for the best way to play the Greek situation is extra cash.

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[i] As measured by the S&P 500