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Bob’s Journal for 7/25

Last update on: Jun 15 2020

Expectations that the Federal Reserve will cut interest rates next week pushed major stock indexes to record highs. However, the fact that the rest of the stock market isn’t doing as well is a caution sign.

The major indexes capture most of the headlines and are doing well as these indexes are driven by the performance of stocks with the largest capitalizations.

The S&P 500 set a new record high in mid-July. For investors who are interested in momentum, the index also is trading well above its short-term, 50-day and long-term, 200-day moving averages.

Some widely followed market internals also are doing well.

For example, the advance-decline line for the S&P 500 has been moving steadily higher. This means that a greater number of stocks are increasing in price than are decreasing in price.

Another positive sign is that almost all sectors of the index have been generating positive returns and many have done so well that they are in or near what market technicians call overbought levels. Only the energy sector is lagging.

The picture is largely the same for the Dow Jones Industrial Average and the NASDAQ 100.

But when we venture outside the indexes that are dominated by the stocks of the largest companies, the numbers tell a different story.

The NASDAQ Composite has been rising lately, but its gains are well below those of the big-company-dominated indexes. The NASDAQ index has declined more than the major indexes in the negative periods over the last year and has increased less during recoveries.

The numbers are worse for mid-cap companies, as tracked by the S&P 400 Mid Cap Index. This index hit new highs in September 2018 and hasn’t come close to returning to those levels, much less establishing new peaks. The S&P 400 is barely above its short-term and long-term moving averages. More importantly, the moving average lines are sloping downward and are giving a sign that the index’s momentum is weak or negative.

Smaller company stocks, as measured by the Russell 2000, are in worse shape. The Russell 2000 is at least 10% below the highs set in September 2018. It is barely above its moving averages and the moving average lines are sloping downward.

Since their September 2018 highs, the S&P 400 and Russell 2000 have been in a trend where they’re hitting lower highs and lower lows. That’s another sign of weak or negative momentum.

Global stocks are also generally underperforming the U.S. large company stocks. The Bloomberg World Index still hasn’t approached its September 2018 high. While above both the short-term and long-term moving averages, the index is barely above those indicators. The moving average lines both are sloping downward.

The media focus on the popular indexes. They make it appear that investors are exuberantly pushing stocks higher.

A closer look, however, indicates investors are cautious about stocks. In fact, stocks of the largest and fastest-growing companies are receiving most of the investment dollars. This might be caused by the increased use of the popular capitalization-weighted index funds and exchange-traded funds (ETFs). It also might be caused by an investor preference for the well-known, fast-growing companies that have outpaced the market indexes the last few years.

But the numbers also are giving us reasons to be cautious.

Growth stocks have outperformed value stocks for some time. Investors seem to be investing in growth and glamour stocks regardless of their valuations. Stocks with already-high valuations have continued to climb in price while stocks that are selling at bargain prices have been ignored.

The recent patterns are similar to what occurred in the late 1990s. A small number of large company stocks were favored by investors while other stocks were ignored. Because the major indexes are capitalization-weighted, this process pushed those indexes higher and masked weakness in the broader market.

It also is worth noting that, even though the major stock indexes are climbing higher, the data on fund flows show that investors have been net sellers of stocks. Fewer investor dollars are pushing these indexes higher. Corporate stock repurchases and other financial engineering are providing support for the major indexes.

Markets began recovering from their late 2018 decline after Federal Reserve officials indicated that they were through raising rates. The recovery became stronger after Fed officials indicated that interest rate reductions likely were on the way.

But investors who believe the Fed rate cuts will support higher market prices should review history. In the past, the Fed tightened monetary policy for too long. Monetary policy easing, such as interest rate cuts, typically occurs only when a recession is in the offing.

I’ve stated several times that I believe that the Fed raised rates too much in 2017 and 2018. Let’s hope that the Fed is easing early enough to avoid a recession this time. The markets might be telling us that it is. In the last week, the Russell 2000 rose 2.03% while the S&P 500 increased only 1.24%.

The Data

Manufacturing stalled in the first half of July while service sector growth increased a bit, according to the PMI Composite Flash Index.

The manufacturing component of the index declined to 50.0 from 50.1. The service sector component increased to 52.2 from 50.7. The composite of the two increased to 51.6 from 50.6. A reading above 50 indicates expansion while a reading below 50 indicates contraction.

The manufacturing index reading is the lowest in 10 years, and several components of that index also are at 10-year lows. The service index reading is the highest since April.

Consumer Sentiment, as measured by the University of Michigan, is holding near its highs. The measure rose to 98.4 for July from 98.2 for June. The current conditions component declined (but still is very high), while the expectations component increased.

The Index of Leading Economic Indicators from The Conference Board surprised many analysts. The index registered negative 0.3% for June, which follows 0.0% for May and 0.1% for April. The index is forecasting very slow growth for the rest of 2019.

Another negative surprise was delivered by the Richmond Fed Manufacturing Index. The index was a negative 12 for July, compared to positive 2 for June. This is the fifth consecutive month that the index was below expectations.

The Richmond Index had been indicating slow, steady growth for months even when many other manufacturing indexes had negative results. All major components of the index were negative. Even so, the expectations for the next six months improved and were positive.

But Durable Goods Orders indicate that manufacturing improved substantially in June. The headline number showed a 2.0% increase in orders for June. May’s orders initially were reported as a 1.3% decline but were revised down to a 2.3% decline. After subtracting the volatile transportation sector, orders increased 1.2%, following a revised 0.5% increase in May.

Importantly, core capital goods showed a 1.9% increase for June, following a 0.3% increase in May. Core capital goods are production equipment that has been purchased by businesses. An increase indicates businesses anticipate increased demand and are gearing up to meet it.

House price increases are slowing, according to the FHFA House Price Index. This index had been stronger than the Case-Shiller Home Price Index for a while. But the FHFA index finally registered a modest 0.1% increase for May, compared to 0.4% for April. The 12-month increase was 5.0%, compared to 5.3% in the April report. The latest number is the lowest 12-month increase for this index since March 2015.

The significant recent change in this index and the Case-Shiller Index is that rates of price increases around the country are converging. Price increases in the once-strongest markets, especially in the Western United States, are declining to match the modest increases in the rest of the country.

Existing home sales declined 1.7% in June, compared to a 2.9% increase in May. The three-month average essentially is unchanged. Sales are down 2.2% over 12 months but are a little higher for the calendar year to date.

Despite the lower sales, the median price increased 2.7% for the month.

New home sales also are fading after a strong start to 2019. Sales for June increased by 7.0% from an unexpectedly dismal result for May. The three-month average is 636,000, compared to the recent peak of 673,000 in April. New home sales for June are 4.5% higher than 12 months ago.

New unemployment claims declined by another 10,000 to 206,000. The four-week average is down to 213,000. It appears that the labor market improved in July after faltering in June.

The Markets

The S&P 500 rose 1.24% for the week ended with Wednesday’s close. The Dow Jones Industrial Average gained 0.20%. The Russell 2000 increased 2.03%. The All-Country World Index (excluding U.S. stocks) added 0.79%. Emerging market equities were up 0.40%.

Long-term treasuries declined 0.15% for the week. Investment-grade bonds increased 0.73%. Treasury Inflation-Protected Securities (TIPS) added 0.08%, while high-yield bonds rose 0.46%.

On the currency front, the dollar increased 0.61%.

Energy-based commodities declined 0.39%. Broader-based commodities fell 0.36%, while gold dipped 0.15%.

Bob’s News & Updates

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I’m a regular contributor to the Forbes.com blog. You can view my contributor page here.

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