“Speak in French when you can’t think of the English for a thing”[i]

Two weeks ago France’s government dissolved – in Paris the capital markets reacted with the CAC 40 (the French stock market index) jumping 2% while interest rates dropped to fresh lows.  Naturally, the mind is immediately overwhelmed with the possibilities of these developments providing similar results in markets around the world including the United States of America.  While it’s possible that the former French government was more incompetent than Washington, Wall Street’s response to a change in our Federal leadership could potentially be beyond belief.

 

Of course, anarchy is not a good outcome, something that even the most callous Wall Streeters realize (or at least most of the callous Wall Streeters realize it).   However, watching the quote screens during the past few weeks it seems U.S. stocks aren’t waiting for a government collapse to move higher. Prior to last week the S&P 500 had not had a down week since the last week of July.  In late August the index reached the 2,000 level for the first time.

 

Of course, reaching this threshold combined with the widespread excitement of the Dow Jones Industrial Average repeatedly reaching records gives the illusion that the entire equity market is having another gangbuster year.  And while the S&P 500 and Nasdaq are providing very nice returns so far in 2014, the Dow was only up 3% year-to-date on September 1st (‘only’ relative to the number of records it has set) while the Russell 2000 increase was less than 1%.

 

Here are the major averages year-to-date results through August. 

2014 YTD[ii]                                  

Dow Jones Industrial Average     +3.1%
 S&P 500                                       +8.4%
          Nasdaq Composite                        +9.7%

Russell 2000                                  +0.9%

 

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends

 

“Twinkle, Twinkle, Little Star”

 

As mentioned, the Dow has gotten a lot of mileage out of a 3% return. However the security that has unexpectedly become the 2014’s star is the long term government bond.  Few realize that many long maturity fixed income securities have provided double digit total returns.  In fact the total return of the long-bond ETF (symbol = TLT) is 16.88% in the first eight months.

 

Please remember that at the start of the year the overwhelming consensus was that bonds were to be avoided.   Yet the 10-year Treasury bond’s yield has declined from 3.03% at the end of 2013 to last month’s low of 2.30% – falling yields mean higher bond prices.  The August low (in yields) might be an important level as the yield has moved higher in September and closed last week at 2.61%.  With the end of QE (although interest rates actually fell when other QE programs concluded) and economic growth seeming to strengthen, perhaps August was the low for the longer end of the yield curve.

 

Staying in fixed income and returning across the pond, Spain sold a 50-year maturity bond at a remarkable yield of 4% in early September.  This is noteworthy in the terms but also given the underlying credit as Spain’s S&P credit rating is BBB or at the low end of investment grade.  It’s astonishing that this got sold at such a long term with such a low rate.  However when we compare it to Germany, it is not that noteworthy.  Investors buying 2-year German debt in August effectively paid the government to invest as the yields were negative.

We wouldn’t expect European interest rates to move higher as ECB president Mario Draghi announced a continental version of quantitative easing.  On September 4th the European Central Bank unexpectedly cut interest rates and said they would begin buying asset backed securities and euro denominated covered bonds in October.  This was a new step for European bankers and is thought to help the economies as they weakened and risked falling back into a recession.

“Or Just a Brilliant Disguise”[iii]

 

The fixed income markets are not the only area of unnoticed deception.  While our aforementioned S&P 500’s accent on the 2,000 is historic, it masks some troubling undertones.  According to Bespoke Investment Group, the average stock in the S&P 500 is down 7.5% from its 52-week high even as the index is making all-time highs.  This divergence is larger within the mid and small cap sectors.  The average stock in the S&P 400 Mid Cap Index is 11.1% lower than its 52-week high and the average S&P 600 Small Cap Index name has plunged 17.3% from its high.  As Bespoke points out, “For this area of the market, the average stock isn’t far from bear market territory”.   Blending it together, the average stock in the S&P 500 is 12.4% lower than its 52-week high.[iv]

 

Breaking it down by sector, Utilities (-6.6%) and Financials (-8.6%) are only sectors where the average stock is not down by more than 10%.  The energy sector is the biggest loser – the average stock is down 19.7% from the 52-week high.  Combining the two weakest sectors (small cap and energy) results in stocks with lower approval ratings than the NFL.  The average small cap energy stock is 29.4% lower than their 52-week high!!

 

That the average stock is weak at the same time that the indexes are reaching record highs is a clear sign of sector rotation together with a narrowing of breadth.  This could be considered a healthy sign in that nothing gets too overheated and there is an eventual recharging of buyer power.  On the other hand, a smaller number of stocks leading the charge to record levels could result in these “generals” ultimately falling and the arrival of the long awaited correction.

 

This rotation could also be a function of the global investment landscape.  Excitement over the new I-Phone together with Alibaba’s IPO and a steady economy is offset by numerous international conflicts, a slowing Europe, an Ebola outbreak, and an ending of US monetary easing.  Interestingly, as these crosscurrents get digested, the S&P 500 has traded in a narrow range in the past few weeks.  At the end of August and beginning of September, the index traded between 1,997 and 2,002 for 8 straight trading days!!  Recently the S&P 500 spent 13 consecutive trading sessions without closing 0.5% higher or lower than the previous close.  We have to return to the year 1995 to find a comparable stretch.

 

MKM Partners researched similar behavior to see what happened after such compression.  Going back to 1980, there were 5 instances where the S&P 500 traded 10 days or more without closing more than a 0.5%.  The average returns after these churns was positive in 1 week, 2 weeks, 1 month and 3 months – respectively 0.85%, 1.24%, 1.83% and 4.71%.[v]  If history rhymes with these past occurrences, the S&P 500 will break out to the up side.  Many are watching 1,990 on the S&P 500 as major support.  This trend could be broken if the index falls below that.

 

France is the 5th largest economy in the world (larger that the United Kingdom, Canada, Australia and the BRICs).  It is remarkable that such an important country’s government can fail and then re-form without much more than a hiccup.  Out of such change opportunities often arise and perhaps this is an indication of political irrelevance together with a sign that the global economy is, in general, doing ok.  And if Europe can take steps to resolve their problems, the S&P 500 might continue to make history.

 


[i] Lewis Carroll, “Through the Looking Glass”

[ii] The Wall Street Journal, August 30-31, 2014

[iii] Bruce Springsteen, 1987

[iv] The Bespoke Report, September 12, 2014

[v] MKM Partners, “Technical Strategy”, September 8, 2014

 

Jeffrey Kerr is a Registered Representative of and securities are offered through LaSalle St. Securities LLC, member FINRA/SIPC. Mr. Kerr is an Investment Advisor Representative of and advisory services are offered through Kildare Asset Management, a Registered Investment Advisor. Kerr Financial Group and Kildare Asset Management are not affiliated with LaSalle St. Securities LLC.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.  The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index.  Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.

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