“I Ain’t Gonna Work on Maggie’s Farm No More”[i]

Every market nerd (hand raised) knows that September’s employment data is released this Friday.  However, last week we got some different yet important jobs related news.  First as everybody knew, Derek Jeter retired.  But the other headline was a real shocker as Bill Gross unexpectedly changed employers.

Derek Jeter, for those who don’t read The New York Post sports page, was the shortstop for the New York Yankees for the past 20 years.  He had an all-star career winning 5 World Series championships and will be voted into baseball’s Hall of Fame.  He announced his retirement before this season began and played his last game on Sunday.

As the financial world knows Bill Gross is the co-founder of Pacific Investment Management (PIMCO).  The firm’s flagship mutual fund, the Total Return Fund, had over $270 billion in assets while the firm wide total exceeded $1.25 trillion as of June 30th.  With these remarkable numbers it is no wonder that Mr. Gross is considered one of the kings of the fixed income market.

Naturally the media was abuzz about Gross’s decision as everyone wanted to analyze both the why as well as its consequences.  Heck we suspect it was even a topic on Friday’s “The View” and “Good Morning America” but only in between fashion updates and coverage of George Clooney’s wedding.

Of course, Mr. Gross’s decision presents more challenges than just learning his way to Janus’s men’s room.  Undoubtedly there will be massive outflow from PIMCO and a corresponding inflow to Janus.  But perhaps more importantly, PIMCO, led by Gross, was noted for its “New Normal” economic forecast.  This centered on a slower potential growth rate for the U.S. when compared to past recoveries.  This included such things as subdued job growth and lower reported inflation.  Further it called for lower than normal interest rates for longer than others were predicting.

This “New Normal” approach resulted in PIMCO being a “vol seller” or taking positions that benefit from lower volatility, lower interest rates, and low inflation.  Reportedly, this was implemented by such positions as long high yield spreads, TIPS (inflation protected bonds), emerging market debt, and maybe some short positions in equity.  As these positions get unwound and re-established, the markets trading those securities could be a little choppier than normal.

Last week’s markets were wild enough without the Gross bombshell.  The Dow Jones Industrial Average moved 100 points or more in each of last week’s trading days – 2 days higher but 3 days lower.  Thursday was especially bloody as the Dow plunged 254 points and all of the major averages lost between 1.5% and 2%.   An astounding 92% of trading volume on the NYSE was in declining stocks.  It was the highest reading since February 3rd.  The glass half-full view is that this can be a sign of capitulation and recent occurrences have happened around the lows of a move.  On the other hand, market internals continue to be poor and traders usually look for capitulation after a more painful correction.

It’s possible, however, that given the declines by the small and mid-cap market sectors (covered in the previous newsletter), the average stock has experienced a meaningful decline and is ripe to recover.  This also points to the narrow leadership driving the major averages which masks the underlying stock market weakness.  For example, on September 19th the Russell 3000 set a new record high.  Significantly, this index equals 98% of the investable stock market.  As the index made an all-time high, only 55% of its components were above their 200 day moving average.  A more typical and much healthier percentage would be above 80%.   The last time such a level of narrow leadership happened was March 2000 – not a good time for the markets.

Coming into the end of September (and the 3rd quarter), stocks have had a tough month.  The S&P 500 is down 1.4% for the month (with two days to go) while the mid and small cap indexes are down over 3% and 4% respectively.  Here are the year to date performance for the major averages.

2014 YTD[ii]

Dow Jones Industrial Average  +3.2%                           

S&P 500                                       +7.3%
Nasdaq Composite                      +8.0%                           

Russell 2000                                 -3.8%                            

I

The lousy performance outside of the large caps, including a painful three months for small caps, might be a function of a correction in the high yield market and strong U.S. dollar.  First, junk bonds reached a multi-year high (in price) toward the end of the second quarter.  Since then these bonds have lost around 3%.  Certainly on the surface this is not an alarming number but in the lower volatility world that is supposed to be fixed income, this is a big number.  Also, it represents a large portion of the 4.5% – 5.5% yield that most high yield bonds provide.

The losses in the junk market might be a result of reduced risk appetites, the end of Fed bond buying (although QE was not in high yield), or worries over the economy’s strength.  Whatever the cause, this sector of the bond market is at the riskier end of fixed income and it usually correlates with stocks especially smaller caps as they use this market for capital.

Turning to the U.S. dollar, it will record its best quarterly performance in more than 5 years with a better than 7% advance.  Looking at a longer term measure, the U.S. dollar index remains well below the levels of early to mid-2000’s, but this recent rise has pressured oil, gold and other commodities.  Crude oil closed last week around $93 per barrel and gold finished at $1,214 per ounce.

As 2014’s 4th quarter begins (head shaking in disbelief), we face typical market cross currents.  On a global stage, we are confronted with protests in Hong Kong, the Ukraine, ISIL, Ebola, and a struggling Europe.  Within our stock market, we have weakening signals and worrisome divergences.  On the other hand, the 4th quarter has historically been the best three-months for equities.  According to Bespoke Investment Group, during the past 100 years October has averaged a gain of 0.22%, while November and December have averaged increases of 0.71% and 1.47% respectively[iv]

Once again it seems that the capital markets are at an inflection point.  Perhaps we are entering a long anticipated painful correction that many have been calling for and we see the large cap indexes move lower.  Or perhaps we regain momentum with the bullish seasonality and we madly sprint to year end.  Or perhaps the correction has already taken place in certain sectors and the areas that haven’t been hit just slither sideways for a while.  We may not get developments such as Bill Gross’s departure from PIMCO but it promises to be an exciting stretch.