Bob’s Journal for 6/30/22

Did You See How the Indexes Changed?

A number of popular stock market indexes were changed, and the updates will surprise some investors.

Many index investors believe they’re investing in “the market” and that their investments aren’t actively managed. That’s not really the case.

The indexes are portfolios of stocks that are selected by committees, often using either guidelines or fairly rigid formulas. The indexes are changed regularly, and changes for the FTSE Russell indexes were made last week.

Among the major changes were that some long-standing favorites of growth stock investors were added to the Russell 1000 Value index and had their weights in the Russell 1000 Growth index reduced.

Not long ago, value stocks primarily were energy companies, banks and old industrial companies.

But now in the value index are Meta (formerly Facebook), Netflix and PayPal. They still have slots in the growth index, but they hold much smaller percentages of the growth index than they did last year. In addition, GameStop has moved to the value index and been eliminated from the growth index.

Also, many energy companies have done so well this year that they are moving from the small company Russell 2000 index to the Russell 1000 index of large companies.

That’s a sample of the changes made in what FTSE Russell calls its annual rebalancing of the index. There will be significant changes in many portfolios, though the investors won’t make any changes and will own the same index funds before and after the updates.

The changes are an indication that there really isn’t such a thing as passive investing and that index investors need to check the details periodically to see what they own and don’t own.

Fear the Liquidity Gap in the Markets

We like to believe that investments trade based on their fundamental factors, but that isn’t always the case.

Since the financial crisis, and especially since the beginning of the pandemic, the Federal Reserve has injected a lot of liquidity into the markets and the economy.

The liquidity injection helped increase the prices of many investments. Bonds did quite well, because the Fed bought a lot of treasury bonds and kept interest rates low.

A good portion of the money the Fed used to purchase the bonds was deployed by investors to purchase growth and speculative stocks, pushing their prices up much faster than their earnings increased.

But the Fed stopped adding liquidity to the markets and recently began withdrawing liquidity. Those moves changed market prices.

Market interest rates rose before the Fed officially raised the interest rate it controls, the federal funds rate, because the Fed stopped buying bonds. There weren’t enough buyers to replace the Fed, so interest rates rose. That’s a liquidity gap.

The liquidity gap moved to the stock markets. The most speculative stocks were supported by the Fed’s liquidity and the floor it effectively put under stock prices. With that support gone, stock indexes have had their worst start to a calendar year in a long time.

The Fed’s not likely to add liquidity to the market until inflation starts declining. In fact, it’s going to keep withdrawing liquidity. Expect the liquidity gap to remain and even grow.

The Investment Rules are Changing

Some rules and relationships that investors have relied on no longer are valid.

Most investors believe that stocks and bonds are uncorrelated. When stocks rise, bonds decline, and vice versa. That inverse correlation is the basis of most diversified portfolios. Bond gains are supposed to offset stock losses.

But this year, both bonds and stocks have declined. The two now are highly correlated instead of being uncorrelated.

Another longstanding belief is that higher inflation is supposed to hurt the dollar. That hasn’t been the case in 2022. The dollar has been quite strong against many other currencies despite the highest inflation in 40 years.

The Japanese yen, which usually holds up against the dollar, has been collapsing.

These changes are results of the extraordinary fiscal and monetary policies of the last few years. These new relationships are likely to continue until the imbalances created by the policies are washed out of the economy and balance is restored in a lot of areas.

The Data

The Consumer Sentiment Index from the University of Michigan was 50 at the end of June. That’s the lowest level since the index began in 1952.

The index was 58.4 in May.

About 79% of respondent were pessimistic about future business conditions, the highest level since 2009. Almost half blamed inflation for eroding their living standards.

The Consumer Confidence Index from The Conference Board plunged in June to 98.7. The index was 103.2 in May, and May’s level was revised down from the 106.4 level reported initially.

Orders for durable goods increased 0.7% in May, following a 0.4% increase in April.

Orders for core capital goods, considered a good measure of business investment, increased 0.5% in May and 0.3% in April.

The Richmond Fed Manufacturing Index dropped to a negative 19 in June from a negative 9 in May.

The Dallas Fed Manufacturing Survey also revealed a lower level of activity in June. The Production Index derived from the survey fell to 2.3 in June from 18.8 in May.

The General Activity Index fell to negative 17.7 in June from negative 7.3 in May.

The Kansas City Fed Manufacturing Index declined to 12 in June from 23 in May.

New home sales in May were 10.7% above April’s level. Also, sales for the three months preceding May were revised higher. But over 12 months, new home sales were down 5.9%.

Pending home sales increased 0.7% in May, according to the National Association of Realtors (NAR). That reversed a six-month streak of declining monthly sales.

Over 12 months, sales decreased 13.6%.

The rate of home price increases slowed for the first time in months in April, according to the S&P Corelogic Case-Shiller Home Price Index. Prices rose 1.8% in April, down from a 2.4% increase in March.

April home prices were 21.2% higher than 12 months earlier, the same 12-month rate as in March.

The Federal Housing Finance Agency (FHFA) House Price Index rose 1.6% in April, up from 1.5% in March. Over 12 months, the FHFA measure increased 18.8% as of April, which is lower than the 19.0% 12-month increase reported in March.

New unemployment claims decreased by 2,000 to 229,000 in the latest week. The average level in 2019 was 218,000.

Continuing claims rose by about 100,000 to 1.32 million.

The third estimate of first-quarter gross domestic product (GDP) was slightly worse than the second estimate, indicating a 1.6% annualized decline in GDP compared to a 1.5% decline in the second estimate.

But the estimate of personal consumption expenditures decreased sharply to an annualized 1.8% increase from an annualized 3.1% increase in the second estimate.

The Markets

The S&P 500 rose 1.49% for the week ended with Tuesday’s close. The Dow Jones Industrial Average gained 1.33%. The Russell 2000 increased 2.56%. The All-Country World Index (excluding U.S. stocks) added 0.71%. Emerging market equities are 0.35% higher.

Long-term treasuries rose 1.76% for the week. Investment-grade bonds increased 0.66%. Treasury Inflation-Protected Securities (TIPS) lost 0.10%. High-yield bonds fell 0.32%.

In the currency arena, the U.S. dollar added 0.14%.

Energy-based commodities lost 1.02%. Broader-based commodities fell 3.00%. Gold declined 0.58%.

Bob’s News & Updates

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