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Analysis: State of the Stock and Bond Markets

October 10, 2012

Conclusion: As stocks rose last week, bonds slipped lower. Losses were concentrated in the longer issues, especially the 30 year maturity bonds, where yields rose about 14 basis points. Yields on the ten year treasury bond gained about 10 basis points, pushing prices lower.
-Dr. Frank James, Founder, James Investment Research, Inc.

Stock Market Analysis

Conclusions: It was a fine week for stock investors. Prices moved higher for the week, the Dow Industrials gaining about 1.3%, about twice the gain as seen in smaller cap stocks. Financials and Health care and staples were standouts for the week, each putting on more than 1%. The only losing major sector was information technology. Although prices moved up each day, the strongest days were Wednesday and Thursday and those were the days of relatively high volume, a bullish sign. It was also bullish that New Highs for the week amounted to ten times the number of New Lows.

Prices have completed a strong rally of about 16% since early June. Toward the end of the rally we have been witnessing a divergence between advancing and declining stocks. Thus, the advance decline line peaked early in April and has never exceeded that point. This has been somewhat reliable of a top in past bull runs, but early. For example, the peak before the 2008 bear market occurred in June 2007 and the absolute SP 500 top in October met with fewer advances. This may be of interest as the 10 day moving average of Advances/ (Declines Plus Advances) is just about neutral (51%), no strong upward push.

There is some evidence prices are overbought, at least in the short term. Prices of the SP500 are bumping onto the top of the 40 week Bollinger band, often a sign of a correction at hand. Stochastics are overbought. Transportation stocks are trending down, even while industrials are rising.

It has been said that one of the objectives of the FED’s Quantitative Easing (QE) is to push up asset prices. The FED has created $2 trillion in its QE and “Twist” operations. While not notably successful in other objectives such as creating jobs and improving growth, stock prices have responded to the inflationary aspects of the program. That may be why the market has moved so well since 2008, the SP500 rising from the 850 area to 1475. Over this time, 79% of the stock trading days enjoyed QE or Twist. And when each of the programs ended (for example in March 2010 and again in June 2011) stock prices peaked and pulled back lower. Larger stocks benefitted the most from QE, smaller issues lost ground.

What of the economy? It appears that new orders for manufacturing are beginning to rise, and according to Purchasing Managers, even a few jobs are being added. Next to new orders, the largest index change was in prices, which are moving higher. Housing is still very depressed; however, it is generating some fresh activity in sales and even modest improvement in construction. In spite of the improvement in jobs, total nonfarm payrolls remain 4 ½ million below the January 2008 peak. However, there has been no increase in the real average hourly earnings of workers, and a slight decrease for the manufacturing worker. Buying power of consumers has not increased.

What else? The debt burden on Americans has decreased, thanks to bankruptcies and write-downs, and it now appears that a modest increase in borrowing is occurring. Last month consumer credit increased by about 1.5%, mostly from changes in nonrevolving accounts (large purchases, not credit cards.) And, the Economic Cycle Research Institute leading index is beginning to move higher.

Previous discussions of sentiment can be summarized: We have abundant evidence of too much exuberance short term. But not so much over the longer term, where an abundance of caution is expressed. Our intermediate risk indictors have experienced only minor changes over at least the past 6 weeks, negatives outweigh positives but not by a large margin. Right now, our best estimate is that we could have a stock correction along with an economic contraction over the next year, but a deep and severe long-lasting bear market is not likely. Long term, we and the indicators remain bullish; Americans tend to force course changes when we go too far astray, and our energy resources will provide a great stimulus to our economy.

F James, Ph.D.

Bond Market Analysis

Conclusion: As stocks rose last week, bonds slipped lower. Losses were concentrated in the longer issues, especially the 30 year maturity bonds, where yields rose about 14 basis points. Yields on the ten year treasury bond gained about 10 basis points, pushing prices lower.