CONUNDRUM

March madness. Nope, we’re not talking college hoops here. Instead we are describing the behavior of the U.S. stock market last month. In short, the best thing to have been long was volatility. Of the twenty-two trading days during March, sixteen registered triple digit changes in the Dow Jones Industrial Average. The bears had a slight edge as nine of the sixteen sessions experienced price declines.

Most of the major indices either established or approached new all-time record highs on March 2, the first trading day of the month. The rarefied air apparently wasn’t to investors’ liking as it was generally a very bumpy downhill ride from there. Sic transit gloria. Nonetheless, the NASDAQ composite was able to finish the quarter with a price gain (not including dividend reinvestment) of 3.5%. The S&P 500, on the other hand, netted a paltry 0.4% gain while the Dow Industrials suffered a 0.3% decline.

Following the time tested baseball strategy of shuffling the batting order when results aren’t favorable, the folks at Dow Jones decided to juice up the venerable industrial average by giving AT&T the heave-ho (and not for the first time) and bringing Apple into the fold. In the past, this has been the kiss of death for the stock being added. For example, RCA (which was a high tech stock back in the day) was added in the late 1920’s after a spectacular run in that decade, but soon thereafter experienced an equally spectacular decline. (We’ll resist making any allusions to one bad apple spoiling the bunch.)

Although a Dow Theory sell signal has yet to be generated, there are some thought provoking non-confirmations to consider. The Dow Transports peaked on November 28 of last year at 9310.22. They closed at 8741.41 on March 31 – a loss of more than 6% despite a huge decline in fuel costs. The Dow Utilities peaked at 657.17 on January 28 and closed out March at 587.08 – a loss of more than 10%.

Bullish sentiment indicators are near record levels (which is a bearish indicator) but the Timex market has kept on ticking albeit with a much more irregular pulse. Bulls can take heart from the fact that April has been the best month for market gains since 1950 with an average return of just under 2%. Ah, spring, the time of year when a young man’s fancy turns to thoughts of…stock speculation.

While all of the machinations described above were occurring in the equity sector, interest rates continued the trend that has been in place since 1982. They declined…again. Yes, despite all of the chatter by the collective talking heads regarding the inevitability of Fed tightening, nothing of the sort occurred and the yield on the ten-year Treasury note fell from 2.17% to 1.93% during the quarter. Yields did rise, however, in the corporate bond sector, especially in the high yield arena; but that is more a manifestation of investor risk tolerance (more specifically, the lack thereof) rather than a widespread anticipation of the Fed applying the brakes (about which there will be more anon).

Commodity prices continued to drop but at a greatly reduced pace versus the second half of last year. In fact, crude oil and gold have experienced a bit of a bounce of late even though it ultimately might prove to be of the “dead cat” variety. The dollar was in the midst of a parabolic rise until the last week of the quarter, when it experienced an overdue correction. Nonetheless, we suspect that this is merely a hiccup in a long-term bull market for the buck.

The economy expanded at a less than sparkling 2.2% annual rate in the fourth quarter of 2014 after showing promise of stronger growth in the prior two quarters. The atrocious weather in the first quarter no doubt sapped some strength from economic growth in that period. Industrial production was up a meager 0.2% and 0.1% in January and February, respectively. Housing starts dropped sharply in February due largely to the poor weather conditions while retail sales that month fell 0.6% - the third consecutive monthly decline.

Payrolls continue to grow at a healthy, albeit not robust, pace while the unemployment rate has fallen to 5.5%. Yet wage gains continue to lag and the economy is not likely to kick into a higher gear as long as this condition obtains.

The “conundrum” to which our title refers is the one faced by our nation’s central bank. Over the past year the Fed cut back on and eventually eliminated the stimulus plan dubbed QEII. Having thus taken the foot off the accelerator, the question now before the money maestros is whether or not to begin applying the brakes. The evidence in favor of doing so would include the aforementioned payroll gains and the record high in stock prices. While the Fed’s mandate has nothing to do with “irrational exuberance”, various members have opined on the subject in the past.

One can certainly argue that record highs in stock prices are not inherently a sign of a bubble. On the other hand, recent IPO activity has been somewhat reminiscent of the dot-com hysteria that preceded the bubble popping back in 2000. To wit, an offering was proposed by one Bigfoot Project Investments – a company organized for the purpose of funding efforts to track down Sasquatch. (No, we are not making this up.) This sounds more like a Kickstarter project to us but any way you size it up, it is proof positive that fools and their money are soon parted.

Yeti sightings notwithstanding, the evidence against the Fed’s initiating a tightening policy appears to outweigh the evidence in favor of doing so by a fairly sizable margin. The central bank’s mandate does include promoting a healthy economy whilst   keeping demon inflation at bay. When we last looked, moreover, signs of inflation were exceedingly scarce. The latest year-over-year change in the Consumer Price Index was 0.0%. The collapse of energy prices since last summer has a lot to do with the weakness in the CPI , but, factoring out food and energy prices, the CPI rose 1.7% - still below the Fed’s target of 2%. Furthermore, it should be noted that most consumers’ perception of inflation is influenced largely by what they see at the gas pump and the grocery store.

There are inflation hawks, however, who believe that the Fed should head off inflation proactively because once it appears, it is likely too late to contain it. History suggests that this argument has merit; yet there are other factors that do not support tightening, chief among which is the dollar’s rapid rise in recent months.

The large whooshing sound in the currency markets of late is the manifestation of capital flowing out of low interest rate countries into the U.S. True, yields on U.S. Treasury securities are at the lowest levels in a couple of generations, but they are still higher than the yields in many other markets. In Switzerland, for example, government securities have negative yields (i.e. investors are paying the government to keep their money). If the Fed were to proactively raise domestic interest rates in this environment, capital inflows would accelerate, and that could be self- defeating.

We’d much rather be a fly on the wall at Federal Open Market Meetings than a participant at the table trying to fathom a solution to the conundrum. It is inevitable that interest rates will begin to rise in the U.S. at some point, but it doesn’t necessarily have to happen in the near future. In the long run, rates will move up; but, as Keynes once remarked, we are all dead in the long run.

 

Weaver C. Barksdale, CFA