Setting Records, Going Nowhere: This Strange All Time High Stock Market.

With one day left to go for the first half of the year, the Dow Jones Industrial Averages are up 1.66 percent year-to-date. The Standard and Poor’s 500 Index is up an impressive 6.09 percent and the Wilshire 5000 Index is up 5.78 percent, but the Russell 2000 Index is up only 2.22 percent. Every index has its own way of selecting and weighing its members, but what does this scattershot diagram tell us about the overall market?

The first thing it tells us is that, year-to-date, industrial America is not the place to be. If you chop and dice the S&P 500, the sector with the highest returns year-to-date is the airline industry, up 45 percent. This is an industry that benefits from operating leverage in the short run, and through consolidation, has kept from collectively adding capacity in amounts that would cause fares to decline.

Other sectors that have done well are the computer and peripheral industry, up 15 percent; gas utilities, up 25 percent; semiconductors, up 17 percent; electric utilities, up 17 percent; and energy equipment, up 20 percent.

Sectors that did not keep up with the S&P 500 averages include air freight, up 1 percent; construction and engineering, down 2 percent; heath care technology, down 7 percent; leisure equipment, down 12 percent; personal health care, down 3 percent; and specialty retailing, down 5 percent.

From this mosaic of information, a few things stand out. Companies with a primarily domestic focus did better than those with international exposure. Information technology continues to be in demand, as do firms that serve the oil and gas industry in the western US. Firms that are most impacted by international trends, especially China, fared poorly, as foreign countries cut back their economic activity.

Investors are increasingly concerned with cash flow from their investments. Utility stocks offer a way to earn a return higher than that of cash, at least at this time. On the other hand, the Affordable Care Act continues to befuddle investors who are trying to figure out who will be the winners in health care going forward.

Entering the year’s second half, there seems to be a consensus that the economy will pick up some speed over the first half. The winter weather did a number on economic data, sending GDP down 2.9 percent in the first three months. The sense is that much of this is being made up.

The stronger economy should translate into faster job growth, which is usually the first building block to a higher level of inflation. As employers surmise that the labor pool is nowhere near as deep as previously thought, the competition to gain and even keep workers will accelerate. This will be the first sign that corporate profits will not be able to grow as fast as GDP, and their contraction will lead to any number of earnings disappointments and stock pullbacks.

Typically, industrial companies such as those who populate the Dow Jones Averages, start to see earnings growth in the medium to late stages of an economic rebound. Because of their size, they do not go down as much as some stocks in recessions, and thus do not lead the charge in the first stages of a recovery. As labor and capacity tighten, these companies tend to benefit from money spent on capital goods to offset wage expense with automation, as well as address new volumes of business due to the economic expansion. However, due to their international exposure, they do better when the rest of the world is growing faster than the US. Right now that is not the case.

The overall tone of the market is different than this time last year. More investor funds are coming into the market to make up for the loss of income on cash. On the margin, there are those who buy social media stocks, which will have their rewards. Afterwards, many investors in such trendy investments will be wiped out.

This is a market that does not treat past as prologue. It never has. The trick is to stay abreast of trends, and try to differentiate the substantial from the passing fad. Also, in a market of this maturity, specific situations mean more than broad generalizations. Successful investment strategies will depend on being more nimble than a crowd whose taste changes by the day, and whose collective memory is short enough to treat some old ideas as new again.

It will be a market that will not want for opportunities, but will want for returns from the same. To earn returns will require seeing further out than next quarter, or even next year. Not everyone is capable of this. Crowds have the attention span of a gnat, and those who cater to them are not much better.

The Economy

Economic activity continues to accelerate. Most people have greeted the negative 2.9 percent first quarter GDP number with various degrees of disbelief.

The second half will be driven by better employment numbers, and perhaps higher wages. This will be most welcome by any number of consumer industries who have been in the doldrums for almost half a decade, as shoppers decide what they can afford and when they can buy it.

The domestic energy industry continues apace. The Keystone Pipeline, while nice, is not necessary for the success of this industry. The first stages of energy exports will help our balance of payments, as well as further boost the employment in the industry.

Interest Rates

Almost without public notice, the Treasury bond buying program continues to be cut back, with a goal of ending the program by December.

The Treasury’s position at this time is to end the purchase of bonds, but not to sell any, preferring to let the bonds mature. As the bonds mature, the Treasury will redeem the bonds and take the funds out of the economy. This fact alone will put a higher floor on interest rates going forward.

Inflation

Americans treat inflation as if it is something that happens to people living in other countries. However, the rate of inflation is picking up, fueled by spot labor shortages combined with rising energy prices.

There is a concern that wage inflation may get out of hand. However, a change in the immigration policy to allow documented workers to stay 3-5 years until their visa runs out may be the best hope to contain wage inflation.

The Stock Market

After a whirlwind last year, it would seem that the stock market is settling into a pattern of more modest returns. This will not be bad, if the returns attract additional investors who can keep the funds coming into the market and hold it up.

This raises the question of what the market will do when interest rates rise. The answer depends on why they rise. If interest rates rise due to increased economic activity, then presumably profits and dividend growth will match the increase in interest rates.

If interest rates rise due to labor shortages without a strong economy, the effects on corporate profits will be significantly different. Lower profits or lower profit growth due to compressing of profit margins would be enough to put a lid on the appreciation of stocks, unless rising dividend payouts help to offset.

Warren M. Barnett, CFA June 30, 2014

Warren Barnett

Warren Barnett is the founder and President, and Portfolio Manager for Barnett & Company. He was associated with the investment banking firm of Kidder, Peabody & Company and the investment counseling firm of Davidge & Company in Washington before returning to Chattanooga to accept a position in the trust department of a local bank. Perceiving the local need for the type of firms with which he was associated in Washington, he established Barnett & Company in 1983. He obtained the Chartered Financial Analyst professional designation from the Institute of Chartered Financial Analysts, Charlottesville, Virginia in 1986. Mr. Barnett graduated from The McCallie School in Chattanooga. He received his Bachelor of Science degree in Accounting from the University of Tennessee at Knoxville and his Master of Business Administration degree in Finance from the Owen School of Management at Vanderbilt University.
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