Good news bears

“Unambiguously positive”. “The best number we’ve seen this year.” “Any doubts about lingering economic weakness in the second quarter, at least as it relates to the labor market, were certainly erased.”

These are quotes regarding the release last Friday of the non-farm payrolls report from the Labor Department which showed that 280,000 people were added to the country’s workforce and around 30,000 were retroactively being added to the March and April jobs totals. Putting that together with the ADP private sector hiring report which came out last Wednesday, we now have almost 3 million people having been added to the labor force over the past year. We also learned that private sector wages and salaries have grown by over 5% in the same period.

All really great news… and yet, the markets drifted lower Friday. What’s wrong with those people?

Well, they really haven’t really ever changed their tune – in spite of what’s been going on all around them for six years. Here’s something from Savita Subramanian, chief US equity strategist at BAML, in her recent Equity and Quant Strategy note. She noted that, “In May, the Sell Side Indicator – our measure of Wall Street’s bullishness on stocks – was unchanged, compared to the prior month. The indicator remains in “Buy” territory, as Wall Street’s bearishness is still more extreme than at the market lows of March 2009. Given the contrarian nature of this indicator, we remain encouraged by Wall Street’s ongoing lack of optimism and the fact that strategists are still recommending that investors significantly underweight equities, at 52% vs. a traditional long-term average benchmark weighting of 60-65%.”

Further, according to the analyst, “Historically, when our indicator has been this low or lower, total returns over the subsequent 12 months have been positive 97% of the time, with median 12-month returns of +26%. However, past performance is not an indication of future results.”

I think that 26% returns may be a bit of a stretch for now. However, this seems to prove that the wall of worry is still very much intact when it comes to top-down portfolio advice from most of Wall Street.

It’s all about the Fed

The main challenge is the big “when will rates start going up” conundrum at the heart of the underwhelming response to the payrolls report. It seems that the financial media has done a fine job of convincing market participants that artificially low rates must be better than actual economic growth.

So, if the good news is that more people are working – and the trend also seems to be reinforcing that – how did this get to be bad news? Easy…if the financial media has convinced you that the only reason the markets have rallied over six years is easy money. See, if more people are working, and wages are rising, there’s really very little incentive or need for the Fed to continue with the rate maneuvering. So, end of easy money equals end of the (investing) world in their view. Therefore, we better sell before things go lower.

While the low rates have caused many investors up the relative risk scale to invest in stocks to get their desired returns, the raising of rates is also, over the longer-term, generally usually good for stocks. That’s because a better economy increases the demand for money which, in turn, moves the interest rates higher. A growing economy should also translate into better earnings for a number of companies. Along with income growth, that combination should be a positive for the stock market going forward.

Another ramification of this combination is that the timing of the rate rise has actually moved up to, likely, September – assuming the current positive trends stay intact. The Federal Open Market Committee will be meeting this week and you can be sure there will be much analyzing done of every word and phrase in order to divine when the big moment will, in fact, occur.

Market moves and rates

The movement of short-term and long-term rates helps determine which types of stocks will do well.

When long-term (10 years or more to maturity) interest rates rise, cyclical stocks tend to outperform the overall market. By cyclical stocks, I mean stocks in those sectors which are closely tied to the economic cycle. When long-term rates fall, defensive stocks tend to lead the market. The defensive sectors are areas such as consumer staples and healthcare; areas that aren’t so hurt in downturns. Consumer staples stocks are considered non-cyclical, meaning that they’re always in demand, no matter how well the economy is performing.

With short-term rates, there’s a slightly different effect. When short-term rates fall, value stocks outperform. When short-term rates rise, growth stocks tend to lead.
When long- and short-term rates both rise, industrial stocks do well. When both rates fall, dividend stocks do well (more accurately, they fall the least). When the yield curve widens, financial stocks do well.

Value stocks are generally in high-dividend areas like REITs and utilities. As noted, when short-term rates drop, investors naturally want those dividends. Growth stocks tend to be relatively low-dividend companies like those in tech and more inflation-sensitive sectors. What’s happening now is that investors are leaving dividends behind and moving towards cyclical areas.

Market fluctuations as a result of this transition are to be expected, sometimes more than others. The key will be to stay with your strategy and tune out the background noise…

Cheers!

Mike

Securities and Investment Advisory Services offered through KMS Financial Services, Inc.

To get an overview of economic conditions, use this link. It’s updated monthly. http://www.russell.com/Helping-Advisors/Markets/EconomicIndicatorsDashboard.aspx

Past performance is not indicative of future returns.

Investing in securities of any type involves certain risks, including potential loss of principal. Investment return and principal value in a bond and/or securities portfolio will fluctuate so that investments, when sold or redeemed, may be worth more, or less, than the original investment.

Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.