After certain measures of the market attained new all-time highs last Tuesday, stocks got clobbered to the downside last Thursday before making a modest recovery on Friday and to start the new week on Monday as well. As a result of all this topsy-turvy day-to-day volatility, the S&P closed lower in back-to-back weeks for the first time since late January while the Dow put in its worst performance in five weeks.
So what is going on here, as there are discrepancies among various market measures all over the place? For instance, as just mentioned, the Dow Jones Industrial Average, the S&P and the Dow Jones Transportation Index all reached best-ever levels on Tuesday. Then during Thursday’s downside market debacle, the Russell 2000 Index of small-cap stocks completed a 10 percent decline from its all-time high reached in early March, which is what is officially known as a “correction.” In other words, how can the one measure that represents the “stock market” to the general public, namely the Dow Jones Industrials, make an all-time high while another measure that includes stocks with a market capitalization of $3billion or less, fall into correction mode at the same time?
The answer is, firstly, that the Russell 2000 outperformed the S&P last year by 5 percent so it was more vulnerable to a setback than its larger brethren, which consists of stocks with a market capitalization of $4 billion all the way up to the largest one — namely, AAPL, with a market cap of $520 billion. And for those unfamiliar with the term, market capitalization means the price of the stock times the number of shares outstanding, as for instance a stock with a price of $50 a share with one billion shares outstanding would have a market cap of $50 billion.
Another reason for the dramatic decline in the smaller stocks is that, at the start of 2014, the average issue in the Russell index was trading at a price/earnings ratio of 24 while the S&P was trading at 15.7 times earnings. This meant that the smaller stocks were more expensively valued than the larger ones and therefore more vulnerable to earnings disappointments, as with the first-quarter reporting period drawing to an end, only 25 percent of S&P stocks have missed their profit projections while 44 percent of the stocks in the Russell 2000 Index have come up short relative to expectations.
Let us also remember that, despite last week’s record high closes in the Dow and S&P, this year has not been the upside barnburner that 2013 was, as the former is ahead for the year by around only one percent while the latter is higher by around two percent.
The reason stocks have not done better in 2014 is that investors have questioned whether the current growth prospects of the economy can justify equities being at the current elevated levels that they are. The economy only grew by 0.1 percent during the first three months of the year and if the miserable weather that adversely affected many parts of the country is partly to blame, then one would think that during the second quarter, economic growth is bound to accelerate. Meanwhile, current projections are calling for an advance of only around 2.6percent.
Economic reports released this past week certainly painted a mixed picture. April retail sales rose by only 0.1 percent after a 1.5percent advance the prior month; April Industrial Production fell by 0.6 percent, its largest decline in a year and a half, and this was primarily due to much lower demand for utilities with the advent of warmer weather; and the May preliminary U. of Michigan Consumer Sentiment Survey fell from a nine-month high in April. On the more positive side, weekly jobless claims declined to under 300,000, which was the lowest level in seven years, and April housing starts rose by the most since last November, as did building permits, which is a measure of future activity.
The bond market has also defied the consensus of supposed market “experts” as yields on longer-term maturities have declined this year when everyone expected them to rise as the economy continued to improve and as the Federal Reserve began the tapering of its former $85 billion a month in bond-buying stimulus which will finally wind down later this year. But to the surprise of fixed-income know-it-alls, the yield on the important 10-year U.S. Treasury Note is currently at 2.50%, down from around 3 percent at the start of the year, and this is the lowest level since last summer.
The reasons for this are somewhat perplexing, but the general consensus is that the bond market is convinced that economic growth is not going to be as strong as originally thought, which means less demand for credit. Then there is the almost universal opinion that the European Central Bank is going to ease policy at next month’s meeting and bond yields in the weakest economies in that region, namely Greece, Spain, Italy and Ireland, have fallen to record lows in anticipation of easier E.C.B. policy. Lastly, there has been what is called “flight to quality” buying during times of geopolitical crisis, as the Ukrainian situation has brought back fears of the old Cold War tensions between Russia and the West.
Since the first-quarter earnings season is virtually over and there are few economic reports this week, the most important potentially market-moving event should be tomorrow’s release of the minutes of the last Federal Reserve Open Market Committee meeting at the end of April. It is assumed that they will say that they are going to continue winding down the stimulus program at the rate of $10 billion a month, which should bring it to a conclusion around October. Investors will also want to hear what Fed Chair Janet Yellen thinks about the state of the labor market, which she has described as “improving” but still “far from satisfactory,” in her words. She remains concerned about the unemployment rate which continues to be “elevated” and those workers who have been without a job for more than six months. It will be instructive to see if these issues are addressed in the minutes and what if anything the central bank is prepared to do about it in terms of revising their interest rate policy.