Market Update for March 7, 2014

The Russell 2000 enjoyed another strong week as the index rushed through the 1200 level, heading on to new highs along with the other major indexes. The Dow Industrials was notably not among them. Construction spending was better than expected, as were the manufacturing numbers out this week, but overall the move to new highs seemed like a relief rally following the easing of tensions in Ukraine.

The stock market now looks very close to a pullback or a sideways trading period, at least in the next week or two. Stocks have rallied sharply from their lows in early February; the Russell 2000 is up 12 percent versus an 8 percent rally in the S&P 500 Index. The S&P 500 Index is only up 1.55 percent for the year, so a small pullback or a couple weeks of sideways trading would keep it flat for the year. We don’t speculate on short-term market moves, but the technical indicators are signaling that the market will take a breather soon.

Longer-term, investors appear to discount the risk from the Federal Reserve’s decision to taper bond purchases. Although the Federal Reserve has stated it will keep monetary policy loose for an extended period of time, it is tightening monetary relative to its peak easing policy from only a few months ago. Given the strength in the asset markets and the solid manufacturing data of late, the Fed will likely reduce asset purchases once more at the March meeting (March 18 to 19). The effects of an even tighter policy will first be felt in emerging markets, but eventually the effects will make their way back to the United States. The result will be either an economy following manufacturing numbers and showing improvement, whereby pushing up rates, or the economy will weaken and asset prices will suffer.

In China there was the first domestic bond default perhaps since the recreation of bond markets during the past 30 years of economic reforms. Financial markets shrugged off the news, but commodities were hit, with copper and iron ore falling in price. China’s central bank has been even more aggressive than the Fed in tightening monetary policy. The banking system is flush with cash at the moment, but this may be in part due to investors exiting the trust market for the safety of large state-owned banks. In the next few months, China will enter a period of heavy debt repayment that will last into 2016, but defaults are already an increasing concern. Any misstep would rattle global financial markets, particularly markets such as U.S. equities that have pushed to new highs.

One sector we’re keeping an eye on is biotechnology. The sector tumbled on Thursday for “no reason”, in the sense that there was no news to trigger a sell-off. Biotechnology stocks are still sitting on huge gains in 2014 even after selling off this week, and they’re only down about 5 percent from the peak. Other momentum leading sectors, such as social media and solar, have not broken down. What makes the drop interesting is that there was no news, which implies it could be due to a shift in short-term investor sentiment. However, given the huge advance in biotech shares this year, the sector could fall another 10 percent and it would still be outperforming the S&P 500 Index for the year.

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