While there is always a bull vs. bear debate in any market environment, the cross-currents in today’s financial markets are fairly stark. Recent stock market action is painting a rosy forward-looking picture, while the action in bond yields is singing a less cheerful tune. So which one is right? That remains one of the difficulties with the current market, knowing which signals to act on and which ones to ignore. Below we try to highlight some of the mixed signals and how we are interpreting them.
As seen in the chart below, the S&P 500 Index touched new highs in early May. The market then pulled back slightly and consolidated for about 6-8 weeks, until early July when it broke out to renewed highs. As a key forward-looking indicator, when the stock market makes new all-time highs it usually portends positive economic trends in the near- to intermediate-term.
Another positive factor for the stock market is the subdued investor sentiment. In the weekly AAII survey of individual investors, the percentage of bearish investors was greater than bullish investors for the last 8 weeks of May and June. Usually when the stock market is making new highs we see bullish sentiment rising, not falling.
Furthermore, when looking at the weekly money flows into and out of mutual funds, we see that investors have withdrawn -$90 billion from equity funds this year alone. At the same time, they have contributed +$220 billion into bond funds. Again, considering how well the equity markets are doing one could reasonably expect to see money coming into the stock market from the sidelines. These last two factors add to the proverbial ‘wall of worry’ that we often discuss, and which frequently characterizes bull markets. There are scant signs of bubbling enthusiasm for this market.
While the stock market paints an encouraging picture amidst favorable investor sentiment, the bond market is giving different signals. If bond investors were favorably disposed to continued strength in the economy, one would expect to see bond yields rising and the Fed continuing to raise interest rates. Yet we are witnessing quite the opposite.
The chart below shows the persistent downtrend in yields that began late last Fall. Yields on the 10-year Treasury bond have fallen all the way from 3.20% last November to below 2.0% recently. That’s a huge move lower for a non-recessionary environment, and has pushed yields to low levels not seen since before the election.
Additionally, the slope of the yield curve also reflects significant reason for caution. Remember the slope of the yield curve is the difference in long-dated bond yields minus short-dated bonds. Currently, the yield curve is ‘inverted’, meaning that short-term 3-month T-bills at 2.16% are actually yielding more than 10-year T-bonds at 2.10%. The slope of the yield curve, once it gets inverted, is often a good early warning indicator of a coming recession. The only problem is the lag time that often occurs before the onset of recession, and said lag time can be considerable.
As for the Fed, we know that they have been trying to use the solid economic strength as a backdrop against which to continue raising interest rates. The Fed knows they will need ammo to cut rates during the next downturn, and would like to build up as many bullets as possible, in the form of rate hikes in the current environment. While the Fed was able to raise rates to 5.25% in 2007 and 6.5% before that in 2000, this time around it looks like they will only get to 2.25%.
The Fed has raised rates 9 times in recent years to get from 0% to 2.25% (fed funds rate), but the market is now pricing in a rate cut at the next FOMC meeting. Chairman Powell’s recent testimony before Congress solidified this notion when he agreed with the notion of a rate cut that was being suggested by the financial markets. So even the Fed is acknowledging that the economy is not firm enough to warrant further rate hikes, and that it appears monetary policy needs to be loosened to continue to support this record-length economic expansion.
While we have primarily focused on the U.S. market, we would be remiss not to mention global markets as well. It is noteworthy that the yield we discussed on the US 10-year T-bond is still an order of magnitude higher than most benchmark bond yields across developed international markets. Yields around the world remain at extremely low levels, despite the fact we are 10 years removed from the Great Recession. The most surprising fact, and frankly one that is a little mindboggling to most, is that there remains $13 Trillion of bonds with negative yields. Huh?
So we have the stock market and the bond market currently pricing in different outcomes. When we look at other indicators, we do see slowdowns, but not precipitous ones. GDP growth is slowing. To wit, US GDP grew 3.1% in the first quarter this year but is currently forecast to slowdown to 1.6% in the second quarter. Corporate profit growth is also slowing. Last year profit growth peaked above 20%, while the current quarter is projected to grow in the low single digits. The question is, with the Fed now in easing mode will this just be another slowdown/pause vs. the end of the cycle?
That is always the most difficult question to answer. We know that we are late in this economic expansion, which recently achieved the record of the longest expansion in U.S. history (121 months). But things don’t appear as overheated as they usually get near the end of a business cycle – inflation remains muted and the stock market isn’t overvalued. That said, at this juncture we don’t feel it is appropriate to increase equity exposure too much relative to where we are positioned. We remain balanced in most of our portfolio allocations, with enough equity exposure to continue to participate in further upside that could come, but remaining mindful of the potential slowdown and that at some point it may be time to focus on paring back risk and getting more defensive.
Jordan L. Kahn, CFA
Chief Investment Officer
Sources: Stockcharts.com; Seeking Alpha; Raymond James; Briefing.com; Standard & Poors; Barron’s; Charles Schwab; CNBC.com
*This Market Monitor is provided for informational purposes only and should not be interpreted as investment advice.