The markets moved sharply lower this week. Through the close Friday, the Dow lost 3.3%, the S&P fell 3.8%, and the Nasdaq dropped 4.1%. Gold lost just 1%, which seems decent relative to the other markets. Oil was a big story this week with a massive loss of 10.8% to close at $35.36 per barrel. The international Brent oil crossed below the $40 level for the first time since 2009 to close at $38.27 per barrel.
Source: Google Finance
There was very little news to move markets this week. It did move a lot, though, largely because of a Fed meeting next week. It is here they are expected to raise interest rates for the first time in nine years, making it slightly more expensive to borrow money.
Perhaps more importantly, it signals a shift away from their stimulative policies we have seen the last seven years that have boosted the market. This has increased market volatility, as we saw this week.
A concern is that as the stimulus policies are removed, the market will have to fend for itself based on fundamentals. These fundamentals have not been pretty – economic growth is steady but slow and corporate earnings have been declining. Sales are even worse. These fundamentals don’t justify such high valuations in the market.
Back to the news of the week, commodities were a big story – oil in particular. Oil prices hit their lowest level in seven years. This was partly due to the strength of the dollar (when the dollar is worth more, you need less of them to buy a commodity) and oversupply.
This week OPEC announced they were not reducing supply and last month saw more oil produced than any other month in the last three years. There’s a lot of oil out there, which is great news as gas prices should move lower.
This has also had a big impact on the junk bond market. A lot of smaller oil-producing companies are classified as junk since they are more risky (also referred to as “high yield”). Lower oil prices hurt the profitability of these companies, which weighs on the junk bond market. These bonds are now on track for their first losing year since the financial crisis began.
The pain in the junk bond market is not just limited to oil companies, too, which makes it more worrisome. Other sectors are performing poorly and defaults are now at their highest level since 2009.
We pay close attention to the junk bond market since it can be a good leading indicator for the broader stock market. In the image below, you can see the high yield (junk) index (in black) and the S&P 500 (in orange) tend to move in tandem. However, moves lower in the high yield index usually foreshadows a decline in stocks. As can be seen below, there is a large gap currently – indicating either stocks will fall or these bonds will have to rise to get back in tandem. This is something to watch closely.
Perhaps more importantly, it signals a shift away from their stimulative policies we have seen the last seven years that have boosted the market. This has increased market volatility, as we saw this week.
A concern is that as the stimulus policies are removed, the market will have to fend for itself based on fundamentals. These fundamentals have not been pretty – economic growth is steady but slow and corporate earnings have been declining. Sales are even worse. These fundamentals don’t justify such high valuations in the market.
Back to the news of the week, commodities were a big story – oil in particular. Oil prices hit their lowest level in seven years. This was partly due to the strength of the dollar (when the dollar is worth more, you need less of them to buy a commodity) and oversupply.
This week OPEC announced they were not reducing supply and last month saw more oil produced than any other month in the last three years. There’s a lot of oil out there, which is great news as gas prices should move lower.
This has also had a big impact on the junk bond market. A lot of smaller oil-producing companies are classified as junk since they are more risky (also referred to as “high yield”). Lower oil prices hurt the profitability of these companies, which weighs on the junk bond market. These bonds are now on track for their first losing year since the financial crisis began.
The pain in the junk bond market is not just limited to oil companies, too, which makes it more worrisome. Other sectors are performing poorly and defaults are now at their highest level since 2009.
We pay close attention to the junk bond market since it can be a good leading indicator for the broader stock market. In the image below, you can see the high yield (junk) index (in black) and the S&P 500 (in orange) tend to move in tandem. However, moves lower in the high yield index usually foreshadows a decline in stocks. As can be seen below, there is a large gap currently – indicating either stocks will fall or these bonds will have to rise to get back in tandem. This is something to watch closely.
One last item of caution from this week. CNBC reports that selling of stock by corporate insiders is hitting record levels (article). This month is on pace to be the fourth-highest month of insider selling ever. This is also a metric we like to follow as insiders obviously have more information about a stock than the general public.
Interesting to note that amid this record selling by executives, the companies themselves are buying back stock at record levels. Why would a CEO sell his stock while the company is buying them back? That just doesn’t look good.
Next Week
There won’t be much economic or corporate earnings data next week. However, there will be a very highly anticipated meeting from the Fed where they are expected to announce an increase in interest rates. Being the first rate hike in nine years, it’s likely to cause a volatile market regardless of their decision, so we could see another rocky week.
Investment Strategy
This drop in stocks puts us near a level we usually find as an attractive buying opportunity for the short run. We will not be doing so, however. There are the concerns we discussed above, plus the uncertainty surrounding the Fed meeting next week. At this point, there is no harm in staying on the sidelines.
Looking out a few weeks or months, it is a little more difficult to determine as we think it will largely be driven by the Fed. The Fed may pull back on their stimulus, but other central banks look to add to theirs. Stocks do tend to be higher into year-end, though.
Longer term, we continue to have worries. Being that much of this rally has been on the back of the Fed’s stimulus, fundamentals like the strength of the corporate sector have been ignored. Once the stimulus is pulled back, we fear markets will sell-off when the deterioration in fundamentals becomes apparent. Corporate earnings are lackluster and revenue has been in a declining trend. A lack of reinvestment into their business signals trouble as money has instead flowed into stock buybacks and dividends. This indicates lower corporate growth down the road.
Bonds did little this week, remaining in the middle of the range we’ve seen since early November. Traders have huge bets out there that bond prices fall (and yields rise) in response to the Fed. Prices are likely to fall, but we don’t think it will be that big of a move as a weak economy keeps bond demand high (keeping prices high and yields low).
Bonds to protect against inflation, or TIPs, remain a good long term hedge for inflation. Floating-rate bonds will do well if interest rates eventually do rise.
Some municipal bonds look attractive for the right client, too. We like buying individual, insured names for these bonds, avoiding muni index bonds if possible. They have not done well recently as a record supply has kept prices low. Therefore, we keep a longer term focus with these investments.
Gold is another good hedge for the portfolio. It is only a hedge at this point – rising on geopolitical issues and when more stimulus looks likely and falling on the opposite.
Finally, in international stocks, we see weakness around the globe and favor neither the developed or emerging markets. However, the stimulus programs in Europe and Japan do make for interesting investments, as long as the currency effects are hedged.
Please note, these day-to-day and week-to-week fluctuations have little impact on positions we intend to hold for several years or longer. Our short and medium term investments are the only positions affected by these daily and weekly fluctuations.
This commentary is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Past performance cannot guarantee results.
Interesting to note that amid this record selling by executives, the companies themselves are buying back stock at record levels. Why would a CEO sell his stock while the company is buying them back? That just doesn’t look good.
Next Week
There won’t be much economic or corporate earnings data next week. However, there will be a very highly anticipated meeting from the Fed where they are expected to announce an increase in interest rates. Being the first rate hike in nine years, it’s likely to cause a volatile market regardless of their decision, so we could see another rocky week.
Investment Strategy
This drop in stocks puts us near a level we usually find as an attractive buying opportunity for the short run. We will not be doing so, however. There are the concerns we discussed above, plus the uncertainty surrounding the Fed meeting next week. At this point, there is no harm in staying on the sidelines.
Looking out a few weeks or months, it is a little more difficult to determine as we think it will largely be driven by the Fed. The Fed may pull back on their stimulus, but other central banks look to add to theirs. Stocks do tend to be higher into year-end, though.
Longer term, we continue to have worries. Being that much of this rally has been on the back of the Fed’s stimulus, fundamentals like the strength of the corporate sector have been ignored. Once the stimulus is pulled back, we fear markets will sell-off when the deterioration in fundamentals becomes apparent. Corporate earnings are lackluster and revenue has been in a declining trend. A lack of reinvestment into their business signals trouble as money has instead flowed into stock buybacks and dividends. This indicates lower corporate growth down the road.
Bonds did little this week, remaining in the middle of the range we’ve seen since early November. Traders have huge bets out there that bond prices fall (and yields rise) in response to the Fed. Prices are likely to fall, but we don’t think it will be that big of a move as a weak economy keeps bond demand high (keeping prices high and yields low).
Bonds to protect against inflation, or TIPs, remain a good long term hedge for inflation. Floating-rate bonds will do well if interest rates eventually do rise.
Some municipal bonds look attractive for the right client, too. We like buying individual, insured names for these bonds, avoiding muni index bonds if possible. They have not done well recently as a record supply has kept prices low. Therefore, we keep a longer term focus with these investments.
Gold is another good hedge for the portfolio. It is only a hedge at this point – rising on geopolitical issues and when more stimulus looks likely and falling on the opposite.
Finally, in international stocks, we see weakness around the globe and favor neither the developed or emerging markets. However, the stimulus programs in Europe and Japan do make for interesting investments, as long as the currency effects are hedged.
Please note, these day-to-day and week-to-week fluctuations have little impact on positions we intend to hold for several years or longer. Our short and medium term investments are the only positions affected by these daily and weekly fluctuations.
This commentary is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Past performance cannot guarantee results.
