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Analysis: State of the Stock and Bond Markets

October 1, 2012

The Russell's survey of investment managers suggested they expect sluggish GDP growth next year, but a recession was not a forecast item. Managers racked up an all-time low in bullishness for large cap and emerging market equities. Technology and energy sectors were favored over utilities and staples. This survey reflects a negative perception for stocks, for sure, over the longer term.
-Dr. Frank James ,Founder, James Investment Research, Inc.

Stock Market Analysis

Conclusions: Last week was a time of solid declines but on lighter volume. Except for utilities, every sector lost ground. Twice as many stocks declined as advanced, however 426 stocks managed to hit new highs against only 29 new lows. Prices fell back every day except Thursday, when volume shrunk on the advance. Commodities were mixed; however, gold, silver, and copper declined while the dollar moved higher against news of European riots.

It is easy to correlate European problems with rises in the value of the dollar, and bond prices. One can likewise correlate investor optimism against announced FED moves (QE3) to pump even more liquidity into the system. Already, about $2 trillion have been generated and placed in Fed accounts; designed to lower the value of the dollar; improve exports; raise asset values and increase employment. There is evidence it has increased the value of assets, including institutional favored large stocks. But presently declining stocks are exceeding advancers, the advance-decline (AD) ratio peaked in early April. This divergence between large market leaders and small stocks is seen at almost every market peak, it is a warning sign.

It does not surprise that printing money does not lead to prosperity - if it did, Argentina would be among the richest of nations.

Knowing our contrarian prejudices against majority opinion, what do we make of the latest sentiment readings?? Long term leanings are shown by:

Public distain for long term investments in stock funds is shown by the latest mutual fund figures. In August 2012 redemptions of stock funds exceeded sales by about $19 billion, more than twice that of July ($9 billion) For the year to date, almost $59 billion has flowed out of stock funds. As this happened, sales of hybrid funds (mostly balanced funds) picked up slightly, by a net of about $1.4 billion. Mirroring this caution, managers increased liquidity to about 4% of fund assets. Annualized redemptions remained a high 25%.

The Russell's survey of investment managers suggested they expect sluggish GDP growth next year, but a recession was not a forecast item. Managers racked up an all-time low in bullishness for large cap and emerging market equities. Technology and energy sectors were favored over utilities and staples. This survey reflects a negative perception for stocks, for sure, over the longer term.

Also negative is the very low allocation for equities in the recent Merrill Lynch global investor survey. What about near term sentiment? The market has just come off a strong 12 month run:

One week ago the percent of investment advisers bullish exceeded bearish views by a very wide 30%. Last week a 26% gap persisted in the Inv Intelligence survey, showing continued strong optimism for stocks.

The VIX fear gage stands at a very optimistic 15.6 reading. Not much "fear" shown here.

The Put/Call trading volume ratio was a super low 0.53 two weeks ago. Calls outweigh puts when optimism reigns. However, the AAII index shows more bears than bulls, a very rare occurrence among small investors.

Mutual fund investors liked bond funds, net new cash flowed into this area of about $26 billion, an increase in August over July by about $4 billion.

Are we getting early indications of a recession? Transportation stocks are off more than 6% over the past quarter, as officials warn about lower traffic and earnings ahead. Observers will note the frequency of recessions during the first year of a presidency; see the first years of Republican Presidents Ronald Reagan and George Bush, and Democrat President Obama.

Fundamental analysis of the economy gives solid warnings as the durable goods orders fell for the third straight month, and by more than 13%. The Kansas City Fed reported lower levels of manufacturing activity. Leading indicators turned negative as did the coincident/lagging index. GDP output figures were revised down from 1.7% to 1.3%, a very low figure and one which won't encourage new hiring.

After a 16% run on the stocks, triggered by FED lubrication, stock prices now show signs of hesitation. The stochastic is beginning to retreat and the advance-decline line is churning with little upside progress.