On Friday, May 2nd, the April jobs report was published by the U.S. Bureau of Labor Statistics showing that 288,000 new non-farm payroll jobs were created in the month. It was the strongest month-to-month growth since January of 2012. In addition, the unemployment rate fell to 6.3%, with 138.252 million people estimated to be employed during the month. This is the highest total number of employed people since March of 2008 and is on the verge of becoming an all-time high in terms of total employment.
The information was published a day after both the DOW (NYSEARCA:DIA) and S&P 500 (NYSEARCA:SPY) set new all-time highs. The immediate response by the market when the jobs information was released was a jump higher. However, by mid-day the market was slightly down, seemingly unimpressed by the job figures, and ended the day on a down tick. Why? Research has shown that while jobs are of course an important economic indicator, they are always a trailing indicator. Anyone trading stocks on the jobs report is searching for fool's gold. The more important aspect of the jobs report is whether the data causes an unexpected change in the expected direction of market influential factors that do impact stock valuations.
Since stocks, as measured by the S&P 500, have advanced over 30% since the beginning of 2012, undoubtedly many market investors have been anticipating higher economic activity. Questions remain, however, whether there are more financial gains to be had in the near term, or whether there are better relative options for investing capital at the present time. For insights into these questions, using the market relevant signals can be very useful in assessing the likely near-term market direction as the winds of change start to blow.
Signals Still Indicate Upward Bias
To track the relative attractiveness of the U.S. stock market as an investment, as published in my book Theory of Financial Relativity, I track 7 market signals formulated from the research in the book to gauge current market risk and relative attractiveness as an investment. The signals are measured as of the end of trading on 4/30/2014 are shown in the following table.
A quick glance at the indicators shows a few precautionary yellow status signals, but no glaringly red warnings. As of early May 2014, there were no clear signals that an imminent major breakdown in the market was about to occur based on historical performance metrics. This statement, however, does not mean that the market cannot move downward, only that the stress points which are usually exhibited for a prolonged and deep market downturn are not yet evident.
In the first few trading days of May both the S&P 500 and Dow traded to new all-time highs. One important signal to watch is how the market reacts as it reaches new pinnacles. Does it have trouble holding its ground, or does it plow right through the old marks and set new highs? In the present trade, it appears the market is not overly enthusiastic about the climb as seemingly good news such as more jobs and better economic activity is greeted with an increasingly choppy trading pattern. The pattern that I follow is one I have named the DOW Signal, which is nothing more than the 12-month first derivative change in the index year over year at month end close. Many market experts watch the 200-day and 50-day moving averages, but I find this metric to be very suitable as a bellwether.
Currently the year over year return on the DOW is in positive territory at 11.7% as of the close on April 30th. The returns as measured every month since the beginning of the year, however, are slowing, meaning that the rate of change in market gains is decelerating. Historically the red warning signal is triggered as the gains approach zero, which may sound like an easy mark to reach periodically; but oddly enough the market almost never breaks through this barrier unless there are serious economic problems in the making. A 10 percent DOW correction at the present time would put the market perilously close to a historically red alarm state. The question is whether other market forces will align to create such a scenario. In the very near term, the bias still appears more upward than down.
Oil Market Continues to be Tame
Every market up cycle has anomalies, which make it unique, and triggers, which make its downfall equally out of the ordinary. As I analyze the current market signals in the context of history, the most unusual aspect of the present indicators is the bond market trading in light of the reports of improving U.S. economic activity and an energy market, which by all measures is remaining well behaved.
If there is one bellwether asset, which has not returned to its previous high set prior to the 2008 financial crisis, it is crude oil. Oil spiked to over $140 per barrel in mid 2008, only to tumble dramatically in late 2008 after the Lehman bankruptcy. (See article Oil's Shocking Market Accommodation) All other markets - stocks, bonds, gold and in many markets even housing - have returned and surpassed the 2008 high water marks. And as stated in the opening of this article, even the total number of people employed in the U.S. has also reached levels set in 2008. However, oil as a traded asset, is still well below its all-time high. The fact that energy has not yet returned to previous high highs may well make the sector the best relative value play option for investors at the present time.
Bond Market Continues to Reflect Distorted Fed Influence
The bond market trade is what I have been most interested in since the start of 2014. In the table above, I have highlighted the 10 / 5 Treasury spread. It has contracted in recent weeks to below 1%, which in historical terms is usually no reason to get alarmed, and the metric is still considered "green" with respect to being indicative of an impending market decline. However, these are not normal "monetary" times, given the largesse of the Fed balance sheet. It is not news to most investors at this point that the Fed owns over 13% of all U.S. Treasury securities and over 18% of all publicly traded Treasuries (foreign entities own 48% of publicly traded Treasuries).
But what may be surprising to many investors is the amount of long duration Treasuries held by the Fed. Currently, due to the Fed bond purchase activities, the Federal Reserve owns $626B of all 10-year and beyond Treasury securities, and it has grown much faster than other maturities on its balance sheet relative to the amount of 10 plus year Treasuries outstanding. I estimate that the Fed owns over 48% of all 10-year and beyond Treasury debt outstanding. (link to Treasury Debt data) The Fed presence in this market has been a focal point in order to influence lending rates on long-term mortgages and business borrowing activities, as well as to reduce the amount of current expenditures the Federal government has to make in interest paid on the National Debt. Currently longer dated maturities have an average coupon of 5% while the remaining debt outstanding is averaging less than 2% and approaching 0% in many maturities. Any interest the Fed earns on the debt held on its balance sheet is returned to the Treasury.
The fall of longer-term interest rates since the beginning of 2014, while the shorter end of the market is rising, is a definitive trend that investors should note and become cautious. A market trading longer dated bonds downward during a time period of accelerating economic activity is unusual. It is caused by government subsidized activity in the form of extraordinarily high Fed long-term bond purchases combined with a decelerating need for U.S. Treasury debt financing.
Government Spending Deflationary Force
Currently the U.S. government year over year growth rate in expenditures fell 2% in the 4th quarter of 2013. (Link to Current Government Expenditure Data) This has not happened since the 1940s. The negative growth rate is highly correlated to the lack of inflation being exhibited in the U.S. economy at this time despite the high level of Federal Reserve induced market liquidity.
The negative growth rate in spending by the government is considered a strong yellow flag for the market, and is very close to turning red. In an inflationary environment I would expect to see expenditure growth more in line with the 1960s and 1970s. Instead, we are currently in a zone only encountered post WWII, albeit not the sharp pullback imposed by the Truman 1946 budget. The current budget détente appears to place the spending levels on a low growth course for the foreseeable future, and if so the stock market will continue to feel a drag. If the 1946 time period is used as a model, the market would correct over 20% from its present level, and eventually Congress would come forward with tax cuts as economic stimulus - but I am always reminded that history never repeats itself.
Geo-Political Risk and Fed Withdrawal not Priced In the Market
In my opinion, market factors not priced into the market currently are what the bid for long dated bonds will be once the Fed truly stops purchases by October of 2014 as projected by top Fed official Fisher? and additionally, what will happen if Washington begins to expand spending levels again due to entitlement programs and / or the unexpected needs for expanded military action due to expanding conflicts worldwide? These are the market forces to watch as the year unfolds. The situation in the Ukraine is but one example of the growing world tension where the road to conflict is seemingly leading, and the resulting costs will most likely be borne in the form of higher interest rates in the U.S. and correspondingly some form of relative valuation adjustment in stock prices. The degree to which stocks adjust is heavily dependent upon the unknown, unknowns of geo-politics.
In 2008, the government leaders were reading from the script, which said "sub-prime is contained." As we progress into the future, will the economic sanction path being laid actually "contain" the current crisis, or will it actually inflame the most likely reason for the growing conflict in the first place? What, you ask, is meant by this statement? Recall my initial point in this article about markets, which have returned and exceeded their all-time highs set prior to the 2008 financial crisis, with the exception of energy. It is well known that Russia is very dependent upon the price of energy in world markets for the growth of its economy. Policy in the U.S. to garner greater energy independence, despite seeming roadblocks along the way from the Obama administration, has led to a blunting of the price for energy. So far in 2014, the trading of oil has been against the grain of the call by many of the so called experts in the securities industry who were looking for oil to fall below $90 per barrel. The price has remained stubbornly around $100, but still has not shown any sign that it will be able to gather steam and spike. Likewise gold, which fell from grace in the spring of 2013, is also remaining well above calls for $1000 per ounce made by many "experts." (See: Gold to tank in 2014: Goldman Sachs) With Russia most likely turning to gold as a currency for trading of energy to overcome it being outcast from the U.S. dollar club, I suspect that as oil priced in dollars moves in the future, so too will the price of gold.
Despite Fed Speak to the contrary, controlling the entire Treasury yield maturity spectrum is going to be difficult, if not impossible in an environment in which the Fed is reducing bond purchases to a more typical $5B-$10B a month. That is why the 10 / 5 Treasury spread has become the likely telling indicator of market risk over the intermediate term. There is still room for flattening to continue, as a 0% spread would be more typical of a sustained market downturn approaching. However, the fact that the spread has contracted 42 basis points to below 1% since November 2013 and Fed bond buying is on the decline means this signal is very likely to be a precursor to the next market breakdown.
Investing Strategy for the Changing Market Environment
In the current market there are investment options that have underperformed over the past several years, which, in my opinion, may be good relative alternatives to blindly sticking to the course of maintaining a 60 / 40 stock to bond portfolio mix. Investors are currently faced with a very likely scenario that the U.S. equity market will either provide low or little return in the intermediate term, and likewise, as the Fed exits the Treasury bond market, eventually rates increasing across the board as long as the U.S. economy continues to expand. In other words, the most overpriced investments in the market right now are fixed rate U.S. Treasury (NYSEARCA:TLT) and Corporate bonds (LAG), and most U.S. equities. The sell-off in the NASDAQ (NASDAQ:QQQ) recently is a sign many investors believe the equity run is nearing a close, and owners of riskier assets are beginning to feel the need to cash in. The high volume of IPOs being rushed to market recently is an indicator of the typical late cycle frenzy to get financing while the market is hot "before the window closes."
In this environment, based on a review of the current market metrics, chances are high that the overall market will stumble along, struggling to reach new highs, but probably not breaking down either at least in the short run unless a re-run of the 1946 deflationary materializes contrary to most expectations. The reason this seems likely is that the market needs to digest the Fed withdrawal and the implications that competing financing needs from the U.S. government in the market that were previously being masked by Fed purchases. Additionally, geopolitical tension is very likely to lead to a new market leadership. The most likely prospects for the new leadership classes in my opinion are in the oil and gold markets. With this scenario in mind, the best investment alternatives for portfolio changes on the margin at the present time can be summarized in four areas:
1) Integrated Large Cap Oil Companies. My favorite in the group continues to be British Petroleum (NYSE:BP). Total (NYSE:TOT) also seems to be an interesting play; however, it has recently seen a sharp run-up in share price and is likely overbought. Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) and Exxon (NYSE:XOM) are also conservative plays with price appreciation potential and high dividend yields. There is the question whether the lack of exploration activities by these large cap companies will hinder their future, while the major shale oil and gas plays move forward full force in the U.S. market in the likes of Pioneer (NYSE:PXD) and EOG Resources (NYSE:EOG). (See article Exxon and Chevron Trailing in U.S. Fracking Boom) My perspective, based on closely following the horizontal drilling space, is that the "pioneers always get the arrows," and the large integrated oil companies will eventually be in a position to buy reserves when needed at a bargain - particularly if the forecasts for cheap oil eventually do come true. Otherwise, worldwide energy prices are going up until the economy goes into a recession.
2) Exposure to the Gold market, whether through the paper market (GLD) or other alternative assets. One fund I continue to like is Gamco Gold and Natural Resources Fund (NYSEMKT:GGN). The fund has a healthy pay-out ratio of 10.6%, and makes consistent investment income by writing covered call options on gold miners and other natural resource companies. A more comprehensive article on my views about the gold market can be found in the blog post Gold, What are Investors Afraid of Now?
3) Variable Rate Loan Funds. As the Fed begins to taper, closed end variable rate loan funds are likely to begin showing a bid. Value in these funds is likely to remain as long as the default rate on business loans remains low and the Fed continues on a track to eventually push up short-term interest rates. Many of the loans in these funds are linked to LIBOR, so any eventual uptick in pay-out ratio is likely dependent upon a change in U.S. short-term interest rates. Funds, which are exhibiting a recent bid up over the past month after being down on average about 10% over the past year include Eaton Vance Limited Duration (NYSEMKT:EVV), Western Asset Variable Rate (NYSE:GFY) and Nuveen Floating Rate Income (NYSE:JRO).
4) Emerging Market Investment Grade Debt Funds. The emerging markets have all been hammered by the Fed's Q3 policy, and I have yet to see a credible market explanation in the major media. The real story is that this has happened in past history, and is directly linked to the combination of Fed policy combined with Washington fiscal constraint. As it appears that both of these forces are likely to abate in the near term, I presently like increasing exposure to emerging market debt relative to the expensive U.S. Treasury and investment grade corporate markets. My views and research behind this market play are contained in the article Emerging Market Debt Options to Hedge the Fed Taper and Stock Volatility. My current favorites in the closed end fund sector are Templeton Emerging Market Income (NYSE:TEI) and Western Asset Emerging Market Income (NYSE:EMD) and Western Asset Emerging Market Debt (NYSE:ESD).
The signals that I follow are not sending a glaring warning message to go to cash at the present time, but they are showing that the tide is shifting. Cash is an expensive asset to hold as it is losing value at the rate of inflation every day. As the winds shift and the scenario analyzed in this article comes into focus, gold is likely to be a better asset to store value until the U.S. equity and interest rate markets return to relative equilibrium.
All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I am long BP, GGN, EVV, TEI, EMD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.