Weekly Stock Market Update—August 9, 2013
By Steve Scranton, SVP, CFA
Chief Investment Officer

Stock Market Update

Typically, stock market activity is lackluster in August, as corporate earnings season news winds down and key institutional players (i.e.; portfolio managers, analysts and traders) go on extended vacations. This has become known in the industry as “the doldrums of summer.” We have been expecting this market behavior to appear on the horizon. However, it seems to be elusive this year. Last week, equities delivered a solid up-trend in performance (the Dow Jones Industrial Average–Dow–was up 0.6% and the S&P 500 was up 1.1%). This week, in a quick turnaround, stocks moved lower. The Dow lost 1.36% and the S&P 500 declined by 0.99%. Last week’s gains were driven by psychological relief after the Federal Reserve (Fed) provided increased clarity about its timeline for winding down the quantitative easing program–which has been widely credited for its contribution to the equity market’s strong gains this year. However, a stream of “Fed speak” this week rekindled uncertainty about the Fed’s potential timing decisions.

These comments caused both the Dow and S&P 500 to fall by a little more than 1% over the first three days of the week. After this “Fed speak” sell-off, equities reversed course and rose moderately on Thursday, after data showed that initial jobless claims rose less than expected, to 333,000 in the latest week.

After a short hiatus, equity investors are back to speculating about when the Fed may start to taper its economic stimulus activities. This week’s stream of comments from Fed officials has rekindled uncertainty—a condition which is loathed by equity investors. Recently, we suggested that the market might pause until the next catalyst became apparent–which it now has. Investors are once again craving clues–and certainty–about the Fed’s next moves.

Current Week Month of August YTD
Dow Jones (INDU) -1.36% -0.35% 19.53%
S&P 500 (SPX) -0.99% 0.43% 20.13%
Nasdaq (CCMP) -0.70% 1.03% 22.19%
MSCI EAFE (EAFE) 0.10% 2.34% 12.67%

Updates to the Equities Buy List:

Company Name News Event Impact to Our Company View
WALT DISNEY CO/THE (DIS) Fiscal second quarter operating earning of $1.03 per share, $0.02 higher than the Street estimate. The company reported it would incur a loss of $160-$190 million on The Lone Ranger film in the fourth quarter.. Unchanged
PRUDENTIAL FINANCIAL INC (PRU) Second quarter operating earnings of $2.30/share topped analysts' estimates of $1.99/share. Unchanged
MEAD JOHNSON NUTRITION CO (MJN) MJN announced resolution of the antitrust review being conducted in the company's business in China. The company will pay a penalty of $33 million, which is expected to reduced GAAP earnings by $0.12/share. Management maintained its 2013 operating earnings forecast of $3.22-$3.30/share. 8/6/2013
COSTCO WHOLESALE CORP (COST) July comparable sales increased 4%, below forecasts of 5.1%, and compared to 3% growth for July 2012. Unchanged
AMERICAN TOWER CORP (AMT) AMT announced it will acquire about 4,500 tower sites in Brazil and Mexico, from NII Holdings (NIHD), for approximately $811 million. The towers have a tenancy ratio of just over one tenant per tower, with Nextel Brazil or Nextel Mexico as the primary tenant. The transacitons are expect to close in 4Q 2013. Unchanged

Fixed Income Update

Even in the face of $72 billion in supply this week, volatility in the U.S. Treasury market decreased. The market is looking for a catalyst but comments from Fed officials did little to affect yields. The gist of their commentary is leaning to tapering of the quantitative easing program, maybe as early as September. The bond market seems to have priced in this possibility but to what degree is the question. For the week, Treasury yields ranged from unchanged to decreasing 5 basis points.

An interesting development could be happening in the Municipal bond market. As interest rates have increased over the past few months, duration extension and de minimis risks, long dormant, could become a factor once again. First, let us review a brief definition of each.

Duration extension risk: For a bond trading at a premium to its call price, implying an expectation that the bond will be called, duration can extend as interest rates rise. This happens when the bond’s call option falls out of the money as the new, higher rate makes calling and refinancing the bond uneconomical. Consequently, the bond, which may have been trading at a yield that implied that its call date was the time when the bondholder would receive full principal, may now trade to its final, longer maturity as the issuer is less likely to redeem the bond early. Non-callable fixed rate bonds do not have this risk.

De minimis risk: While coupon interest income on municipal bonds is typically exempt from federal taxation, appreciation is treated as ordinary income. So, if you purchase a tax-exempt bond at a discount (below face value) then the appreciation back to face value is normally treated as capital gains. The price appreciation on a bond purchased at a discount in the secondary market may be taxable as ordinary income if the discount is too big. The de minimis rule determines if the market discount is taxable as capital gains or ordinary income by setting a boundary, below which an investor’s tax liability may increase notably.

In the municipal bond market, according to Morgan Stanley, 73% of outstanding bonds have a call option. Of this group, 99% have maturities greater than 10 years and 85% are trading over par (in other words, trading to the shorter maturity call date). Thus, if interest rates move higher, this group could face higher relative rate sensitivity as prices adjust to the longer maturity date.

Bond prices are a function of the coupon rate, payment period, maturity date, and the current interest rate. As interest rates increase, bond prices decline. The move higher in rates since March has increased the percentage of bonds trading at a discount that is below the de minimis boundary. According to Morgan Stanley, 6% are now below de minimis (from 2%) and the group between de minimis and par has increased to 9% from 3%. If interest rates increase 60 basis points, 20% of the market would be subject to the de minimis rule; 84% of the universe of these bonds have maturities 15 years or greater.

Both duration extension and de minimis risks are concentrated in the intermediate and long end of the muni curve. We are currently managing portfolios to a much lower duration to mitigate these unique risks inherent in the municipal bond market. If we buy bonds close to or subject to de minimis, we make sure that clients are adequately compensated. Likewise, if we buy bonds with a call feature, we analyze them to both the call date and final maturity to make sure they are attractive under both scenarios.

Company Spotlight

Reported quarterly earnings. Sold $1.0B in 3 and 5 year notes. Buy / Buy
A2/A/#N/A N/A
Reported quarterly earnings. Buy / Buy

August 9, 2013

Current Last Week Week Change Last Year Year Change
Tax-exempt MMF 0.06 0.07 -0.01 0.21 -0.15
Taxable MMF 0.01 0.02 -0.01 0.17 -0.16
2-Year Treasury 0.30 0.30 0.00 0.27 0.03
5-Year Treasury 1.35 1.36 -0.01 0.73 0.62
10-Year Treasury 2.57 2.60 -0.02 1.69 0.88
30-Year Treasury 3.63 3.69 -0.05 2.76 0.88
5-Year Exp. Inflation 1.93 1.94 0.00 1.92 0.01
2-Year Agency 0.41 0.39 0.02 0.39 0.02
5-Year Agency 1.63 1.62 0.01 1.05 0.58
10-Year Agency 3.24 3.24 -0.01 2.31 0.93
2-Year Corporate* 0.76 0.74 0.03 0.82 -0.06
5-Year Corporate* 2.24 2.23 0.02 1.76 0.49
10-Year Corporate* 3.84 3.84 0.00 3.01 0.82
30-Year Corporate* 4.84 4.85 -0.01 4.12 0.72
2-Year Municipal** 0.59 0.59 0.00 0.43 0.16
5-Year Municipal** 1.47 1.51 -0.04 1.02 0.45
10-Year Municipal** 3.09 3.07 0.02 2.22 0.87
30-Year Municipal** 5.06 5.01 0.05 4.07 0.99
Fed Funds 0.25 0.25 0.00 0.25 0.00
Prime Rate 3.25 3.25 0.00 3.25 0.00
Dollar*** $81.11 $81.91 -$0.80 $82.64 -$1.53
CRB $285.38 $283.77 $1.61 $304.81 -$19.43
Gold $1,313.80 $1,310.60 $3.20 $1,617.10 -$303.30
Crude Oil $106.03 $106.94 -$0.91 $93.36 $12.67
Unleaded Gasoline**** $2.91 $2.99 -$0.09 $2.70 $0.21

Note: Agency and Municipal yields are as of the previous business day.
* Composite A
** General Obligation AA+
*** Int'l value of the U.S. dollar (Avg. exchange rate between the dollar and 6 major world currencies).
**** Futures price per gallon