Up and Down Wall Street

Is the Bull Market Running Out of Steam?

With U.S. growth slowing, central banks running out of ammunition, and a tumultuous presidential campaign likely, the signs aren’t good for stocks.

By Randall W. Forsyth
 

Is the reflation rally about to deflate?
 
Since Feb. 11, when the U.S. stock market pulled out of its early 2016 tailspin, the Standard & Poor’s 500 index has rebounded by some 14%, leaving it up about 1% for the first four months of the year.
 
But the large-cap benchmark stalled just short of the peaks touched last May, and last week slid 1.3%—its worst showing since the week ended on Feb. 5, just before the recovery began.
 
It has been dubbed a reflation trade because it has been led by commodities, notably crude oil, which has run up more than 70% from its lows in the mid-$20-a-barrel range to the mid-$40s.

And that has been accompanied by a 3% drop in the U.S. Dollar Index.
 
Pixabay
 
           
Whether that’s because of the rumored pact among major central banks to stop the dollar’s ascent, which had been exerting deflationary pressures on commodity prices and squeezing emerging economies dependent upon them, or is just the course of events, you make the call.

Regardless of where the truth lies, Feb. 11 also coincided with confirmation that the U.S. economy is losing steam. The ever-alert Stephanie Pomboy charted the Atlanta Federal Reserve Bank’s GDPNow estimates for first-quarter gross-domestic-product growth in her latest MacroMavens missive, and found that it peaked at 2.7% on that date. From there, it slid steadily, to a final prediction of 0.4%, which was within a rounding error of the advance report released last week of a 0.5% annual real growth (after inflation).

And, just coincidentally, from that time on, the federal-funds futures market effectively cut its forecast for rate hikes by the Federal Reserve. With the prospect of less tightening by Janet Yellen & Co., a weaker dollar, and a rebound in commodity prices, the high-yield bond market recovered strongly. For those keeping score, the yield premium on junk narrowed by about a third, to 5.66 percentage points from a peak of 8.44 percentage points on Feb. 11.

In March, the Federal Open Market Committee implicitly confirmed that it had dialed back expectations for four quarter-point rate hikes this year to just two, citing risks in global economies and financial markets. Last week, the FOMC held its rate target steady, but dropped the reference to that risk—not a surprise in view of the aforementioned recoveries in risk markets.
But the Bank of Japan surprised the world by failing to come through with further stimulus measures, such as pushing its policy rates further into negative territory. And with the European Central Bank having already laid out its various stimulus schemes to try to expand credit, if the major central banks aren’t all in, they’re close.

In any case, stocks slid in the final two sessions of the week, with big tech names leading the way lower. In particular, Apple (ticker: AAPL) took a big hit after reporting disappointing earnings. It fell more than 11%, to $93.74, its worst week since January 2013. Former Apple fan Carl Icahn, who had called owning the stock a “no-brainer” and had previously opined that it was worth $240 a share, last week said that he had sold his position at less than half that price target. Icahn also warned of a “day of reckoning” for the market overall, “unless we get fiscal stimulus.”

Whether selling out of the world’s biggest stock represents a short-term trading tactic or a longer-term strategic move is unknown. What is known is that it’s May, and no doubt you’re sick of hearing that it’s time to sell and go away.

Even if it seems a dubious strategy, that’s the history. And the folks at Bespoke Investment Group looked a bit more deeply into the record and found that how the market fared during the dreaded May-to-October period also depended on what it did from January through April.

Looking back at S&P 500 returns from 1928 to 2015, stocks did worst if the first four months of the year were relatively flat: plus or minus 2%, the range that this January to April’s 1% falls into. In the 16 such flattish years, May through October returns averaged minus 0.21%. For the full year, stocks turned in positive returns 56.3% of the time.

When the S&P 500 was up more than 2% through April, as it was in 45 years, the average return for May to October was plus 2.99% and those months’ showing was positive a hefty 71.1% of the time. And when the year started with a downer (off more than 2% in the first four months), as it did 27 times, the average gain was 1.11%, and May to October ended up in the plus column 53.6% of the time.

It’s different this time, as the oft-repeated phrase on Wall Street goes. What will distinguish the next five months is a presidential campaign likely to be among the most contentious in U.S. history. That will come against a U.S. economy at near-stall speed, global uncertainties, and central bankers running out of policy tricks. Summer days may not be hazy and lazy, but crazy, almost certainly.

“I GOT DEBTS THAT NO HONEST MAN CAN PAY,” Bruce Springsteen dolefully sang in “Atlantic City,” a tune that is even more apt today than when he wrote it in 1982. Then, gambling seemed to hold the promise of reviving the New Jersey seaside resort, and for a time it appeared successful.

But that was before a wave of bankruptcies (including that of an entity bearing the name of the “presumptive” Republican presidential nominee) shuttered a third of its casinos, hitting the city’s economy and blowing a hole in its budget. On Monday, Atlantic City is expected to miss a $1.8 million bond payment, which would be the first default in the Garden State since the 1930s.

That, of course, is dwarfed by the financial crisis in Puerto Rico, which faces a $422 million debt payment on Monday on obligations of its Government Development Bank. An even bigger, $2 billion issue comes due on July 1, and includes an $800 million payment on the commonwealth’s general obligation bonds, which, under Puerto Rico’s constitution, are supposed to be paid before anything else.

Meanwhile, despite House Speaker Paul Ryan’s call last December for Congress to come up with a solution to Puerto Rico’s crisis, there seemed little urgency last week, regardless of the looming default.

None of this should surprise investors, especially in the case of Puerto Rico. Last year, the island’s governor said the $70 billion in debt “is not payable.” But that was nearly two years after Barron’s Andrew Bary first warned of the rising risks in the debt securities issued by Puerto Rico’s myriad borrowing entities (“Troubling Winds,” Cover Story, Aug. 26, 2013).

Events such as Detroit’s bankruptcy and defaults by Stockton, Calif., and Jefferson County, Ala., have shaken the municipal bond market, the New York Times asserted in a recent article.
Investors seem to have missed the piece, which warned of increasing credit risk in munis.
Instead, they poured some $1.17 billion into municipal-bond funds in the latest week, according to Lipper data, the most since the $1.3 billion in the week ended on Dec. 30.

To the contrary, history shows that municipal defaults are far less prevalent than those of comparable corporate bonds. According to Moody’s Investors Service data cited by Charles Schwab, triple-B munis (the lowest investment grade) had a default rate of 0.32% from 1970 to 2013, versus 4.61% for comparably rated corporates—and even lower than triple-A corporates, at 0.49%. Schwab does point out that muni rating standards have become aligned more closely with corporates’, so a former triple-B muni might now be rated single-A.

Moreover, against the widely publicized strains in these challenged credits, the overall muni market has rallied strongly. The iShares National Muni Bond  exchange-traded fund (MUB) has returned 4.57% in the past year, compared with 2.35% for the iShares Core U.S. Aggregate Bond  ETF (AGG), according to Morningstar. Indeed, as our Current Yield column reported a couple of weeks ago, muni funds have bested all other bond funds and diversified stock funds in the past year.

And returns on some leveraged closed-end muni funds have exceeded 20% in that span. That includes tax-free yields north of 5%, equivalent to upward of 8% from a taxable security to someone in the top federal tax bracket (and more for state-specific funds for investors in high-tax states.)

Nothwithstanding the Gray Lady’s frets, the greater risk to muni investors isn’t the prospect of failures, but rather past successes. That is, munis are no longer cheap. Double-digit discounts from net asset value have largely disappeared from muni closed-ends, with some actually trading at premiums. And top-grade long munis no longer offer an absolute yield advantage over Treasuries; 30-year triple-A munis on Friday yielded 2.54%, versus 2.67% for 30-year T-bonds.

To be sure, some states and municipalities, notably Illinois and Chicago, face massive unfunded pension liabilities.

But the muni market offers myriad well-secured credits, particularly revenue bonds backed by solid projects. And with a few exceptions, many major muni-fund groups were getting out of Puerto Rico credits around the same time that Barron’s sounded its clarion call, attesting to the value of professional management in this highly heterogeneous market.

And as for Atlantic City and Puerto Rico, the Boss offers this hope:

“Everything dies, baby, that’s a fact. But maybe everything that dies someday comes back.”

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