May Ends with Sharp Rally

This year the market has been challenging for even the most patient investors.  In May we saw extremes in both directions of the market.  The first three weeks of May brought heavy selling and a new closing low for the year on the S&P 500 index.  When the S&P 500 broke through 4,100 points on May 19th it took out the previous low set in March.  Then a sharp rally took control of the market in the last week of the month and most of the May losses were recovered before the month ended.  

There has been a lot of selling this year.  The NYSE is a universe of over 3,000 of the largest companies in this country and the average stock on the NYSE is down -34% from its high. The three hardest hit industry sectors this year are technology (-20%), communications (-25%) and consumer discretionary (-26%).  Together they make up almost half of the S&P 500 index.   

It is no wonder that pessimism is running high.  Usually, investor sentiment doesn’t change until a rally is well underway.  Sentiment is often a contrary indicator because extreme pessimism reigns at market bottoms.  

We continually look for evidence that the market is improving and the bond market is one of the places we look.  In recent days we have observed a tightening in the credit spread between US Treasuries and High Yield Corporate Bonds.  The credit spread is the difference in yield between a US Treasury and a Corporate Bond of the same duration.  When investors are more open to risk they buy corporate bonds over US Treasuries.  A demand in corporate bonds moves the price up and the yield down.  As the yield gets closer to the yield on the US Treasury, the credit spread narrows and that condition is favorable for stocks.  The tightening credit spreads we are observing now are a positive indicator for stocks.

Bond investors determine longer term rates and the yield on the 10 year US Treasury is a good indicator to watch.  Mortgages and other long term debt are tied to this rate.  It doubled in the first four months of the year and hit 3.16% early in May.  This is an indication that the bond market is pricing in inflation.  It dropped back to 2.7% by the end of May, and climbed back to 3% on June 6.  As of this writing it is pulling back again.  If the yield holds below 3% that would be positive for stocks and may indicate that bond investors expect inflation to taper off in the coming months.   

The pressures this economy has faced for months are still present, but the market usually recovers before the economy.  Interest rate increases by the Fed this summer will not surprise the market.  Those increases are likely already baked into the price of stocks.  Inflation will be with us for a while, but the aggressive actions of the Fed since March should slow down the rate.  

The sharp drop and equally sharp rally in May could be an indication that we have seen the worst of this market.  That does not mean it will be smooth sailing.  Investors should expect continued volatility and stock selection is critical to success.  There are definitely buyers for stocks in the marketplace confirmed by the strong up days. We can’t predict the bottom and neither can anyone else.  The bottom cannot truly be known until it is over.   If positive indicators continue to surface, it is encouraging that we may at least see a summer rally.  

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