Is the Bond Market Sending a Message for Stocks?
After the news-heavy calendar last week, there are few market-moving economic reports in the week ahead. It is also the quiet period for the Fed. How will the punditry fill those empty minutes?
Last week’s trading revived a question that many find puzzling. I expect pundits to be asking:
How can bonds and stocks both be so strong?
Last week the economic news was mixed, but the market showed strength anyway.
In my last WTWA I took note of the big economic calendar and short week. My conclusion was that we might finally see some volatility. Wrong! The news was close enough to expectations that the reactions were modest. Since there was little volatility, it never became the theme for the week.
The Story in One Chart
I always start my personal review of the week by looking at this great chart from Doug Short via Jill Mislinski. The gain for the week, achieved entirely on Thursday and Friday, was almost 1% and another new all-time high.
Doug has a special knack for pulling together all the relevant information. His charts save more than a thousand words! Read the entire post for several more charts providing long-term perspective, including the size and frequency of drawdowns.
I am considering some changes in WTWA. Instead of launching “new Coke” without proper testing, I would like reader suggestions. I have outlined the ideas here, and I welcome comments and suggestions.
Each week I break down events into good and bad. Often there is an “ugly” and on rare occasion something very positive. My working definition of “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!
The economic news last week was mixed, but the market reaction was positive.
- Personal income and spending both increased 0.4%, positive but in line with expectations.
- Household deleveraging has been “historic.” Since this news is contrary to most of what you hear, it is important to read the excellent global macro update from BlackRock.
To be balanced, we must also note the increasing leverage of corporations. BlackRock notes that this reflects the low cost of loans versus equity. More of the lending locked in for a long period.
Any assessment of debt and leverage must include government. It is a concern, and on my writing agenda.
Consumer confidence declined slightly, but remained at a high level – 117.9. Here is the analysis from the Conference Board:
Consumer confidence decreased slightly in May, following a moderate decline in April,” said Lynn Franco, Director of Economic Indicators at The Conference Board. “However, consumers’ assessment of present-day conditions held steady, suggesting little change in overall economic conditions. Looking ahead, consumers were somewhat less upbeat than in April, but overall remain optimistic that the economy will continue expanding into the summer months.
- ISM manufacturing beat expectations with a solid 54.9 reading. The Chicago PMI (Calculated Risk) notched its highest reading in 2 ½ years.
- ADP private employment showed a gain of 253K. Regular readers know that I regard this as an alternative source on the jobs situation, neither better nor worse than the BLS.
- Pending home sales declined for a second straight month. (MarketWatch). Once again, low inventory was blamed. Steven Hansen (GEI) has an interesting take, comparing historical household formation and replacement needs, to new supply.
He writes as follows:
Based on the data in the above graph, since the beginning of the Great Recession there were almost a half million more new homes constructed than households formed. Up until the 21st century, there was good correlation between household formation and homes constructed.
However, historically 300,000 new homes are needed each year to replace those lost to fires, rot, other causes, or simply torn down to make way for new construction. Based on just replacements needs, 3 million new houses were needed since the beginning of the Great Recession instead of the half million above household formation actually constructed. The green line in the above graph is the combined need for new housing (year-over-year gain of households plus the replacement housing).
The bottom line is that the NEED for new construction is outpacing the supply. It seems the price for new and existing housing is above the price many buyers are willing (or can afford) to pay. It seems that there is a shortfall also of buildable land near many metros where people want to live.
- Corporate profits may have peaked. (New Deal Democrat)
- Legislative chaos from the Trump budget. Stan Collender’s pessimistic viewpoint has five negatives, including a 60% chance of an October government shutdown and reduced chances for tax reform. Stan is an experienced Washington insider, so we should pay attention. I strongly agree with the need for some compromise. That said, it seems overly pessimistic to me.
- Auto sales declined slightly to a seasonally adjusted annual rate of 16.6 million and may have peaked. This means that companies will be competing for market share. Everyone will be watching to see if this is a peak or a plateau.
- Initial jobless claims rose by 13K from an upwardly-adjusted prior week. The widely-followed four-week moving average also increased by 2500. Some observers are poised to see any increase in this level as a sign of danger. Doug Short has a key chart, which adjusts the results for the size of the labor force. It is great work, and something to keep in mind.
- Construction spending dropped 1.4%, the largest decline in a year. (Reuters)
Employment situation disappointed in both the non-farm payroll report and the household survey. The headline net job gains of 138K significantly missed expectations. The prior two month reports were revised lower by 66K. The household survey was weak. None of my regular sources showed any enthusiasm about the employment picture. Calculated Risk summarizes the general reaction to this report.
The headline jobs number was below expectations, and there were combined downward revisions to the previous two months. Is this slowdown in hiring a short term issue, part of the normal business cycle, or due to a Trump Slump? My view is this slowdown in hiring is mostly part of the normal business cycle (my expectation was job growth would slow further this year).
There was still some good news – especially with the unemployment rate falling to 4.3% (lowest since 2001), and U-6 falling to 8.4% (lowest since 2007). But overall this was a disappointing report.
The opioid epidemic. Ohio is suing five drug companies for contributing to that state’s epidemic (Fortune). Some companies cannot find enough workers who can pass drug screening (Washington Post).
And at the low end of those trying to make a buck out of the, “addict brokers” find people whom they can induce to travel to a rehab facility. They qualify them for short-term insurance, and then abandon them after it runs out. (Stat).
The Silver Bullet
I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. This week’s award goes to David Templeton of HORAN Capital Advisors for his timely refutation of the latest “scary chart.” It is so easy to create these bogus parallels. If you want page views or retweets, this is the ticket. Here is the chart making the rounds:
And here is what you get if you use percentage changes, since the absolute price levels are not similar.
The Week Ahead
We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.
After the big reports last week, it is a light calendar.
The “A” List
- ISM services (M). Continued strength expected.
- JOLTS (T). Little understood report helps identify tight labor markets. A Yellen favorite.
- Initial jobless claims (Th). Continues at near-record levels.
The “B” List
- Factory orders (M). Noisy April data, but eyes remain on recent industrial weakness.
- Wholesale inventories (F). More April data, subject to varying interpretations.
Crude inventories (W). Recently showing only modest impact on oil prices, and even less on stock prices.
FedSpeak is on hold for the quiet period in front of next week’s FOMC meeting. Those craving a “Fed fix” will have to rely on the pundits – most of whom claim to know more than Fed members anyway!
Next Week’s Theme
In a light week for data with no FedSpeak. That won’t stop punditry speculation about next week’s meeting, of course. And there is the constant possibility of a market-moving tweet. In this absence of this stimulus, what might be the theme for next week? There is already bemused head-shaking about Friday’s trading. If the employment news was weak, causing a rally in bonds, why did stocks move higher?
I expect pundits to be asking:
Is there a bond market message for stocks?
The divergence is simple.
- Some believe that the bond market is “smarter.” This suggests that stocks do not reflect economic weakness.
- Others feel that the markets are somewhat disconnected, with many stocks reasonably valued in a low-growth environment.
- A few believe that bond yields reflect irrational recession fears or a distorted view of future Fed policy.
Most market participants seem to subscribe to the first of these three choices.
As usual, I’ll have more in my Final Thought.
We follow some regular featured sources and the best other quant news from the week.
Whether you are a trader or an investor, you need to understand risk. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update.
The Indicator Snapshot
The Featured Sources:
Bob Dieli: The “C Score” which is a weekly estimate of his Enhanced Aggregate Spread (the most accurate real-time recession forecasting method over the last few decades). His subscribers get Monthly reports including both an economic overview of the economy and employment.
Holmes: Our cautious and clever watchdog, who sniffs out opportunity like a great detective, but emphasizes guarding assets.
RecessionAlert: Many strong quantitative indicators for both economic and market analysis. While we feature his recession analysis, Dwaine also has several interesting approaches to asset allocation. Try out his new public Twitter Feed.
Georg Vrba: The Business Cycle Indicator and much more. Check out his site for an array of interesting methods. Georg regularly analyzes Bob Dieli’s enhanced aggregate spread, considering when it might first give a recession signal. His interpretation suggests the probability creeping higher, but still after nine months. Here is an update of his recession indicator based upon the unemployment rate.
Brian Gilmartin: Analysis of expected earnings for the overall market as well as coverage of many individual companies.
Doug Short: The World Markets Weekend Update (and much more). His Big Four chart is the single best method to monitor the key indicators used by the National Bureau of Economic Research in recession dating. The latest update shows the most encouraging picture in over a year.
How to Use WTWA (especially important for new readers)
In this series, I share my preparation for the coming week. I write each post as if I were speaking directly to one of my clients. Most readers can just “listen in.” If you are unhappy with your current investment approach, we will be happy to talk with you. I start with a specific assessment of your personal situation. There is no rush. Each client is different, so I have eight different programs ranging from very conservative bond ladders to very aggressive trading programs. A key question:
Are you preserving wealth, or like most of us, do you need to create more wealth?
Most of my readers are not clients. While I write as if I were speaking personally to one of them, my objective is to help everyone. I provide several free resources. Just write to info at newarc dot com for our current report package. We never share your email address with others, and send only what you seek. (Like you, we hate spam!)
Best Advice for the Week Ahead
The right move often depends on your time horizon. Are you a trader or an investor?
Insight for Traders
We consider both our models and the top sources we follow.
Felix, Holmes, and Friends
We continue with a strongly bullish market forecast. Most of our models are fully invested. The exception, Road Runner, is fussy about entry criteria. The group meets weekly for a discussion they call the “Stock Exchange.” In each post I include a trading theme, ideas from each of our five technical experts, and some rebuttal from a fundamental analyst. This week we took up the important question of how to deal with a losing trade. Many traders do not really have a plan for this crucial issue. RoadRunner plays upward trending channels and likes NetEase (NTES). See the post for charts and a lively discussion.
Top Trading Advice
Pradeep Bonde has two interesting posts this week. He explains the advantage of looking at absolute momentum. This contrasts with most common methods, usually based upon a calculation based upon comparing with other stocks.
He also suggests some swing trading criteria, focusing on 8% moves. Look at his data to see why.
Insight for Investors
Investors have a longer time horizon. The best moves frequently involve taking advantage of trading volatility!
Best of the Week
If I had to pick a single most important source for investors to read this week it would be Tom Brakke’s big picture take on modern investment analysis. In a helpful technique, he describes a persuasive example about new technology in farming. Readers who understand this are then invited to consider the use of volatility as the key measure of risk.
This is excellent, thoughtful analysis, and it is presented well. We pretend to understand issues with precision. We would do better to make modest improvements on the big risks.
Brian Gilmartin takes a multi-post look at the financial sector. He asks a question on the minds of many: Is the decline a buying opportunity?
Our Stock Exchange always has some fresh ideas. Holmes takes a look at Credit Suisse (CS).
Blue Harbinger summarizes the data on value stocks and what might be the catalyst for a rebound in this group. Hint: Volatility – which would hit riskier stocks the hardest.
Dividends and Yield
Chuck Carnevale is unhappy with current valuations for the top dividend stocks. I enjoyed his video, where he goes through a history of some past picks. I was happy to note that we currently own only the candidate he identifies as undervalued, while considering one that is close. I strongly recommend studying this to understand a great stock selection method, as well as the current market.
By contrast, Blue Harbinger finds some attractive candidates for a put-writing strategy. (This is similar to our own approach of writing OTM calls. Some of his names are in our universe).
Barron’s finds 6 dividend stocks that “hedge against inflation.”
This is a great topic for analysis.
Check out the advice and links from David Snowball at the Mutual Fund Observer. One feature is his citation of Bill Gates who tweeted this year’s advice.
Abnormal Returns always has first-rate links for investors in the weekly special edition. Investors will find value in several of them, but my favorite is from Bob French (Retirement Researcher). In his argument for investors to look less frequently at their portfolio results, he compares random data to actual performance. Can you tell which is which?
Seeking Alpha Senior Editor Gil Weinreich continues to provide advisors and investors alike with intriguing ideas and links. He frequently highlights articles that I would otherwise miss. I particularly enjoyed this post where he highlights Jim Sloan’s intriguing comparison of Buffett and Einstein. I’m not entire convinced, but it is a great topic for thought.
Bill Kort takes up the ever-changing narrative on bubbles. Is Dr. Shiller really bullish?
Week after week we see focus on a specific issue when the underlying question is one of valuation. Let me take a slightly different approach to this question. Suppose that you anticipated ten percent inflation next year. What rate of return would you expect from your bank, from bonds, or from stocks? When inflation was that high, interest rates were even higher and stock PE’s were low. In a world of low inflation, why is it surprising that people are willing to accept lower anticipated returns.
The anticipated inflation rate of market participants can be determined from the constant maturity ten-year note yield, and TIPS. Here is the result:
With this in mind, let us revisit the “mystery?” Many analysts focus on inflows and outflows, risk on and risk off, Trump trade or not. This simple (simplistic?) interpretation presents stocks and bonds as an alternative.
While it is true that each asset class is always part of a relative comparison, the overall valuation in any asset reflects inflation expectations. Moreover, the long-term relationship between stocks and bonds is positive. Viewed in this way, we should not be surprised by Friday’s trading, or by similar reactions.
Those who consider inflation expectations as part of the valuation question will have more accurate results.
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