A Divided Market

There are clearly opposite views on the market right now.  After a fabulous day for all three indexes yesterday, not to mention the performance of many leading stocks, some commentators remain committed to the idea we are headed for a recession.

A week ago, recession fears were plastered on the front pages of all the major financial news services.  This week we witness a string of outstanding earnings from consumer-based retailers like Home Depot, Walmart, Lowes and Target.  Target hit the ball out of the park sending the stock up 20% on better than expected sales and earnings.

So which view is right?  The one where we are teetering on the verge of a recession or one with a robust consumer and generally constructive economic news?   If you have been following the recession fear story it is based on the bond market yield curve inversion where interest rates for short-term bonds rise above long-term bonds.  When this takes place a recession usually happens.  It is important to note that during ALL of the prior recessions following a yield curve inversion in the last 50 years, The Fed was in an interest rate tightening mode. Today they are easing.  The other thing to note is prior recession following an inversion is some recessions to nearly two years from the inversion to materialize.  A yield curve inversion is a noteworthy development, but like many aspects of the bond market, you have to put it into the context of this ultra-low rate environment.

The global economy is slowing, in part due to the trade war with China.  The president has decided the short-term pain is worth the long-term benefit of bringing manufacturing jobs back to the U.S., protecting American intellectual property and preventing China from spying on American citizens.  So far the U.S. economy has been very resilient.

The doom and gloom crowd seem to have a reasonable argument.  The rest of the word is having a tough time, The Fed appears confused about what to do with interest rates and tariffs are hurting global trade.

In the U.S. interest rates are on the decline, innovation is alive and well, labor markets are healthy and we had a fairly good Q2 earnings season.

Investors know the likelihood is very high, at some point we will enter a recession.  Right now, there is simply very little evidence a recession is pending.  Of course, if one happens in the next two years, which is always a possibility, some will gleefully point back to August of 2019 as evidence of the pending event.  The real take away, the timing of a yield curve inversion and a recession is unhelpful outside of a rising interest rate environment, in my opinion.

We are more likely to see massive monetary stimulus and possibly even fiscal stimulus as a method of avoiding the next recessions before it happens.   Policy makers have been telling us they already have their fingers on the money printing button.

The two biggest factors holding back the U.S. is interest rates and tariffs.  So far Tariffs have had little effect broadly but that could change as an agreement is delayed.  Interest rates are hopefully headed down, so we are more in line with the rest of the world, which should be good for U.S. investors.  We will know more this week as the Kansas City Federal Reserve host their annual meeting in Jackson Hole, Wyoming.

One more factor about interest rates.  Investors know the Fed controls short-term rates.  But what about long-term rates, why are they so low?  Simply put, demand from foreign investors.  Negative interest rates in other parts of the world is causing money to flow into the U.S. bond market.  That demand causes prices to rise (see chart below) and yields to fall.  This dynamic also causes the Dollar to rise as foreigners have to exchange their Yen or Euros into Dollars to purchase U.S. bonds.

We could explore about what may be holding back Europe (high taxation, high regulation, liberal social programs) and Japan (immigration policy) in more detail.  In the meantime, we are fortunate to have many investment opportunities to choose from in the U.S.

Stocks Turn Bearish

The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years.  As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.

Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher.    Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.

In terms of Monetary Policy (central banks), we are in uncharted territory.  On the one hand, market intervention potentially provides a mechanism to avoid financial contagion.  On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going.  The US and Europe are looking to reduce their exposure to globalization trends.

In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.

Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy.  Investors should expect more market intervention going forward.  My job is to manage the effects it has on investments and purchasing power.  Right now, it is looking like global markets are bracing for another round of asset deflation.

The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds.  With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall.  That is not happening.  Money is moving to the safety of the 10-year Treasury bond.  Money flows to 10-year Treasuries when it is concerned about asset deflation.  10-year Treasury bonds are again yielding less than 3%!  Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.

Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels.   It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.

For this reason, I believe it is a good time to be a bit more defensive and raise cash levels.  Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices.  Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.

The Grind To Lower Valuations

Let’s think about the future for a moment.  After all, that is what the stock market is doing constantly.  Up to this point in 2018, the stock market has had a very positive view of the future.  Why wouldn’t it?  Corporate sales and earnings growth have delivered in the strongest economy since 2008.

In addition to an economy that is strengthening, we are also experiencing an innovation renaissance.  Quantum computing, space exploration, and organ replacement are just a few of the areas announcing major breakthroughs.  If you spend any time following science and technology news, rarely a week passes without a new scientific announcement.  Contrast that with the DotCom crash of 2000 where we were at the end of the personal computer revolution of the 1990.  The future did not look very bright.

The most important market to watch right now, in terms of what the near-term future may hold for stocks, may be high-yield (junk) bonds.  Many commentators point to the increase of debt by corporations as a major risk for the economy.  So far it is holding up remarkably well which is not what you would expect if the economy was about to fall in to a recession.

At some point in the future we will see another credit event like the sub-prime debacle of 2008.  That is the nature of a credit-based global economy and it will likely trigger a deep recession.  Perhaps we are on the verge of such an event but the high-yield market does not seem to think so.  It is holding up remarkably well considering how much corporate bond doom and gloom is being reported.

Stockcharts.com, Dightman Capital

If there were serous concerns in the high-yield bond market you would expect a bigger sell-off, but instead high-yield bonds appear to have decoupled from stocks.

I shutter to think what the global economic environment would be like without the corporate tax, personal tax and regulatory reform recently implemented in the U.S.  But I digress, that is the past.  What is more important is will these policies allow the U.S. economic expansion to continue?

In its totality this selloff has the character of a grind down to lower valuations; not a panic selloff with no bottom in sight.  I think the biggest surprise of this market could be the Dow, S&P 500 and Nasdaq reaching new all-time highs before we actually experience the next recession.  There are many things that could go wrong but I continue to believe we are experiencing an adjustment in valuations that will allow this market to resume the bull market rally; not the beginning of the end of the this cycle’s expansion.

Are Cracks Forming in the High-Yield Bond Market?

While high-yields bonds (HYG) have held up better than equities, there are signs of cracks forming.

Negative developments at GE have caused some to speculate more highly leveraged borrowers are looking at downgrades.  The lower tiers of investment grade ratings currently represent a large number of bonds and if we see a series of downgrades pressure could mount on the corporate bond market, both investment grade and high-yield.

I am still viewing this entire episode as a cycle slowdown and not the end of the cycle.  The Fed will likely put the break on interest rate hikes in 2019 if credit markets continue to rumble.  The real estate market has already broadcast a slowdown and change in buyer behavior attributed to higher interest rates.  Weakness in the corporate bond market has their attention.  One aspect that may be overlook in the corporate market, however, is the impact of corporate tax reform on the ability of borrowers to service debt more effectively.

The U.S. economy is still doing well and there may be more to come if congress can get together on an infrastructure project.  Trade talk with China remains a risk but so far the impact to the U.S. has been limited.

I have set another alert for the high-yield market.  Should it trigger I will become more concerned about junk bonds rolling over which would likely represent a negative development for stocks.

Will Higher Interest Rates Derail Stocks?

Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%.  This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years.  For that reason, I believe the Fed is going to be cautious with moves above 3%.  Remember, one of their stated goals initially was to be able to “normalize” short-term rates.  I believe they will have accomplished that goal when they reach 3%.

Stockcharts.com, Dightman Capital

The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve.  The silver lining for the current rate environment is a steepening yield curve.  The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate.  A strengthening banking sector should benefit the broader economy.

Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.

Stockcharts.com

Real estate price appreciation should also slow as financing costs rise.  There is some evidence in certain markets that price increases have slowed or stalled.  Stocks too, will compete with higher bond yields as rates move higher (more on this below).

In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks).  Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20.  On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth.  An increase in input costs could result in higher prices.

Trade disputes may influence inflation but it could be temporary in many cases.   There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some.  Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher.  Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern.  It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible.  Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.

The U.S. Economy remains healthy; October started with a trio of good news.

  • The ADP payrolls report hit 230,000 in September, beating estimates
  • The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
  • September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58

The U.S. Stock Market continues to like the economic environment.  Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.

It is important to remember a diversified portfolio will have a mix of investment returns.  While certain parts of the stock market are delivering nice returns, some categories are under performing.  Many dividend stocks have not had a particularly strong year.  Bond yields are part of the reason.  The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields.  Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.

Earnings-Growth Expectations for Q3 remain strong.  The view from FactSet  suggest earnings growth between 20-25% for the period.

So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018.  We remain in a very constructive economic environment despite ongoing trade negotiations.  As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead.  This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close.  Don’t be surprised if this pullback ends up being 5-10% deep.  Primarily due to interest rates and trade talks.  As of the close on October 8th, the S&P 500 was down less than 2%.

2018 Investment Strategy Review

Stock and bond market performance has been more volatile in 2018.  After an amazing run in 2017 stocks have become more sensitive to interest rate hikes and potential disruptions in global trade because of ongoing trade negotiations by the Trump administration.

Bonds too have seen an increase in volatility as the Federal Reserve increases the Fed Funds rate and sell bonds from their balance sheet.

The start of the year was extremely volatile for both asset classes but over the last month U.S. stocks and bonds have settled down.  Other asset classes are still struggling.  Emerging market bonds are down over 4% and emerging market stocks have declined nearly 10% according to statistics from ETFReplay.com.

Over the years I have tracked the performance of 4 classical investment strategies from pillars in the industry. Here is a quick look at how they are doing so far in 2018.

Note:  This data is historical and does not reflect actual account performance.  Please see the performance disclosure below for additional detail.  The benchmark for each strategy is the iShares Moderate Growth ETF (AOM).  It is important to remember the CAGR (Compound Annual Growth Rate) for all these strategies are only  using approximately 6 months of data.  Year-To-Date (YTD) performance and volatility is provide below each summary.

We start with our baseline “Classic” Strategy Year-To-Date (YTD) performance.  This strategy is considered a blue-chip approach to investing by several well respected investors.  This mix of investments represents 60% U.S. stocks and 40% U.S. Bonds.

YTD:  Classic Return:  2.8% vs. AOM Return 0.0%     Volatility:  9.7% vs. AOM Volatility 6.0%

Next, we will look at the YTD performance 3-asset class strategy we call the “Cycle” strategy.  This strategy holds 5 investments from 3 asset classes.  It is the lowest volatility strategy I manage.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Cycle Return:  0.6% vs. AOM Return 0.0%    Volatility:  5.5% vs. AOM Volatility 6.0%

Adding more asset class, next we feature a “risk parity” strategy YTD performance.  In this approach 7 asset classes are weighted based on their volatility (or risk) with lower volatility investments receiving a higher weight.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Risk-Parity Return:  -1.7% vs. AOM Return 0.0%    Volatility:  4.1% vs. AOM Volatility 6.0%

Finally, the most diversified of the bunch, the 10-asset strategy YTD performance.  This approach invests equally in 10 asset classes.  The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.

YTD:  Ten Asset Return:  -0.4% vs. AOM Return 0.0%    Volatility:  5.8% vs. AOM Volatility 6.0%

It is clear 2018 has not favored highly diversified strategies.  Those strategies that focus on U.S. stocks have performed better.

For a real shocker, here is how 10 select industry groups I incorporate into my strategies have performed YTD.  This is an all stock selection, so the benchmark has been changed to the S&P 500 (SPY).

YTD:  Industry Group Stocks Return:  16.3% vs. SPY Return 5.6%    Volatility*:  19.5% vs. SPY Volatility 16.1%

*Note the significant increase in volatility associated with the portfolio of Industry Groups.  That is the trade-off for exposure to high-growth areas of the economy.

We don’t know what the future holds but as we embark on a new generation of product and service innovation, along with stronger economic performance in the U.S., I have been guiding clients to overweight U.S. stocks and incorporate industry groups from areas of the economy expected to grow faster than the general economy.  It has been working well and has the potential to add value for years to come.  In addition, I can include industry group exposure to any of the strategies above where risk-management characteristics should generally reduce volatility.

All the statistics provided by ETFReplay.com.

Past performance does not guarantee future results.  Investments and the income derived from them fluctuate both up and down.  Investments at Dightman Capital are subject to risks including loss of principal.  No specific investment recommendations have been made to any person or entity in this written material.  This presentation is for informational purposes only and is neither an offer to sell or buy any securities.  Benchmarks or other measures of relative market performance over a specified time period are provided for informational purposes only.  Dightman Capital does not manage any strategy toward a specific benchmark index.   A variety of sources we consider reliable have provided information for this presentation, but we do not represent that the information is accurate or complete.  Dightman Capital Group does not provide tax advice to its clients.  Conduct your own research or engage an investment professional before making any investment decision.  Investors are encouraged to discuss any potential investment with their tax advisors.  The material provided herein is for informational purposes only.  Data Sources:  IDC, Dightman Capital.

Stocks Finally Correct, What’s Next?

After an outstanding 15-month stock market advance, last week stocks experienced a significant pullback.  The S&P 500 declined 3.9% but all three major U.S. stock indexes remain in positive territory so far in 2018.  After outstanding performance in 2017, U.S. stocks started 2018 on an even more accelerated run with the Dow Jones Industrial Average gaining 7.6% during January, before last week’s pullback.  The stock market rally needed to slow down.

In terms of earnings, Factset reports as of February 2nd approximately 50% of the companies in the S&P 500 have reported actual results for Q4-2017.  Of those, 75% are reporting actual earnings-per-share above estimates compared to the five-year average.  In terms of sales, 80% are reporting actual sales above estimates; the sales and earnings health of U.S. publicly traded companies appears to be good.

The likelihood of additional interest rate hikes in 2018 may have been the trigger for last week’s stock market correction.  Jerome Powell is the new Fed Chair and futures markets are expecting another 75-basis point increase in Fed Funds in 2018, which would bring the rate to around 2%, still below the historical average.  Investors also saw declines in bond prices last week as the 10-year Treasury yield shot up to 2.92%.

The continued improvement in economic numbers along with the overall optimism and rapid pace of innovation currently underway could suggest we are a long way from interest rates causing a sustained decline in the stock market.

Don’t be surprised if stocks are up big on Monday.  We could see more selling but a lot of cash remains on the sidelines and some investors have been looking for an opportunity to enter this market; one of the reasons stocks have not given much ground since President Trump ushered in a new set of economic policies aimed at broad sustained economic growth.

I have said this before and I will repeat it here.  We could very well see the the Dow at 30,000, the Nasdaq at 10,000 and the S&P 500 at 5,000 before we see the next bear market.  For those that do not understand how this could be, let me remind you; stocks went nowhere for 14 years from 2000 – 2013.  In the four or so years since the S&P finally regained a new all-time high in 2013, the stock market spent 18 months in a trading range between 2015-16, as the U.S. teetered on the verge of falling into a recession.

We have a combination of conditions that are conducive to a continued market rally:

  • Low Interest Rates
  • Positive Economic Policy
  • An Innovation Renaissance

Unlike prior market cycles, this one may not last as long as those previously for a couple reasons.  First, this expansion comes on the heels of a recovery that started 8 years earlier.  Second, a tremendous amount of debt was created in the U.S. and globally as the primary policy for recovering from a debt crisis.  If you are shaking your head, you should be.  Eventually we will pay a price for policy mistakes used to address the 2008 financial crisis.  Until then it is a race between economic growth and debt growth.  The next crisis could very well come from a country needing to restructure their debt.

In terms of interest rates, it appears we have some breathing room.  The 10-year Treasury yield remains well below levels of the last 20+ years.

In terms of short-term rates, if the Fed Funds rate were to rise above 3% the economy should be doing exceedingly well.  However, government debt funding is more sensitive to short-term rates, so policy makers are likely to take funding costs into consideration as they move rates higher.  Fortunately, other broad economic factors appear to be holding inflation in check which should allow The Fed to keep short-term funding rates at or below normal levels.

Until The Fed has turn up interest rates to a point of slowing the economy, the stock market is likely to continue rallying…there are amazing investment opportunities in the next generation of biotechnology, materials, software, and much, much more.  It is truly an exciting time to be an investor which is another reason I believe more money will find its way into the stock market over the coming years.

Please let me know if you are interested in learning more about investment opportunities from innovations in finance, travel, technology and more in a risk-managed, proactive approach.

Stock Index Performance Calculations, Stockcharts.com

Yield data from Stockcharts.com, Investors Business Daily.

How Markets Reacted To A Trump Victory

stock-market-gainsInstead of a Brexit market reaction last week investors appeared to position for the impact a Trump presidency could have on the U.S. economy and asset markets. There is a limit to how much any administration can accomplish during the first couple of years but investors appear to be favoring some asset classes while avoiding others.

One of the most welcome surprises was the terrific performance of small cap stocks, up 2-3% on Wednesday, outperforming all the other broad U.S. stock indexes. For the week the Russell 2000 (IWM) was up 10%. The potential for a reduced regulatory burden appears to have given this group of companies a big boost.

International stocks, on the other hand, did not fare well last week based on potential changes to international trade. It does not sound like this is going to be an initial focus other than trying to bring trillions is cash from U.S. companies being held abroad. International developed market stocks (EFA) ended the week up just under 1% while emerging market stocks (EEM) took a hit, down -4%.

In addition to the stock market sending a positive message about future economic growth, the sentiment was echoed in the Bond market. A December rate hike was already priced in U.S. Aggregate Bonds (AGG), down just over 1% since highs this summer. They fell an additional 1% following election results. An expected fiscal stimulus package is likely the culprit sending bond prices lower. 10yr Treasury yields (IEF) have moved back above 2% and look headed higher.

Industry group rallies were also evident last week. One of the more promising may be the move in Community (QABA) and Regional Banks (KRE) both up about 15%. One of the biggest moves was in Biotech (XBI), up over 20%. Metals and Minerals (XME) had a big move as well, up nearly 11% on potential infrastructure spending. Retail (XRT) was also up over 8%.

In other asset classes, gold (GLD) was hammered indicating the rise in yields is based on rate normalization and not inflation. Gold has rallied strongly this year and remains above intermediate term support around $1,200 an OZ.

In currencies the U.S. Dollar (UUP) was a big winner, up 2% for the week. Interestingly, the British Pound (FXB) rallied in tandem with the dollar last week but is down significantly since Brexit. The Yen (FXY) and Euro (FXE) turned in losses for the week.

There are many remaining issues that could derail what looks like a market expecting positive developments from a Trump administration. With a considerable amount of capital on the sidelines investors can expect more money to come back into the market and push some investments still higher. Given the pre-election concern about a Trump victory, the market vote of confidence last week was a great way to get started.

How The Presidential Election Could Impact Stocks and Bonds

presidentialelection2016

 

U.S. investors find themselves on the verge of a historic election clouded by controversy not seen in decades, even lifetimes.  Combined with mixed messages in related areas: A rare strong GDP number (subject to revisions), a Federal Reserve on and off with raising interest rates (they are on again for a December hike) and a positive bias to earnings season so far; it seems anything could happen.  The circus we are witnessing between government, candidates, news reporting (and of course WikiLeaks) is exposing the worst in humanity.  Who would have thought a computer shared between Huma Abedin and Anthony Weiner would have trumped (sorry about the pun) all the email stories to date!

Investors would be naive not recognize the potential for coordinated manipulation of asset markets.  We know global banks were recently fined for manipulating LIBOR interest rates and there have been many previous instances of bad behavior in the industry.  That is why Dightman Capital focuses on combining multiple well-constructed strategies for a growth portfolio designed to weather a variety of market and economic conditions using straight-forward investments in specific combinations.  Let us know if we can help you find investment success in a world of uncertainty.  Based on Friday’s response to the breaking Weiner email story from seized electronic devices, more short-term stock market volatility should be expected.

In another sense this market environment is no different from what we have experienced throughout the current administration:  An ability over the last 8-years to guide the news narrative along with markets.  All of that may be about to change, or is it?  Time, it turns out, may be the biggest enemy to current economic and market conditions.  I would caution against taking too bearish a view.  We simply do not know the threshold where markets reject monetary expansion.  Outside of a surprise event that derails markets, current conditions of an upwardly trending stock market, mediocre economic growth and lower than normal interest rates are likely to mostly remain in place via the big fiscal ambitions of both presidential candidates.  Most elections have little impact on markets direction near-term and that would be more true if this was not such a controversial election.

After this year’s election results are announced we might see near-term volatility like the U.K. market reaction to the Brexit vote back in June.  U.K. stock investors have taken the development in stride since the vote with stock prices trading just below levels prior to the vote.

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Many stock markets have been trending sideways since this summer; one reason markets could eventually return to rally mode later this year or early in 2017.  The chart below compares U.S. stocks (IWV), International Developed Country stocks (EFA) and International Developing Country stocks (EEM).

iwvefaeem5md

Bond markets are a different matter altogether.  Instead of trying to hold an 8-year rally, like the stock market, bonds have a multi-decade rally to contend with.  A rally that has pushed interest rates to minuscule levels.

The Fed has signaled they would like to move forward with a rate hike in December and the futures market is currently pricing a 70% likelihood.  Regardless of Fed action bonds are due for a pullback as prices have risen above the top of a multi-decade channel.

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More evidence of higher rates can be seen in the price action of interest rate sensitive industries like real estate investment trusts (IYR) and utilities (XLU), both of which have come under pressure.

iyrxlu4md

Markets are always only a crisis away from sending bond prices higher and yields lower as investors look for a safe-haven.  With no shortage of international and domestic tension on the rise, we can’t count that out.  But outside of a surprise scenario bond prices look headed lower in the near-term and probably over the intermediate term as well.

Once the election dust settles stocks look poised to continue their advance on the back of new fiscal policy and ongoing monetary policy.  If the next president can pass a fiscal spending package it might be just the cover the Fed needs to continue raising rates.  A couple trillion $ directed into the economy could go a long way towards sustaining the current path for stocks.  Regardless, it looked like the next president of the United States will either be a wildcard potential change agent or a president marred in controversy.  The market will likely discount some controversial headlines as long as credit conditions remain favorable and economic growth is maintained.  Changes in either of those two areas and the next President might find the going a bit tougher than the last one.

The Stock Market Prepares for Higher Interest Rates

U.S. stocks have been stuck in a trading range since the middle of July. Q3 earnings and central bank policy are likely to be the factors driving near-term market direction but any number of wildcard events could derail a rally attempt. The market is currently priced for perfection but that does not mean it can’t go higher. In 10 years is it likely to be significantly higher.

SPY4mD101116

Q3 earnings expectations are not very high. Market consensus currently suggest this will be the sixth straight quarter of earnings declines. An earnings contraction of this duration has never happened before without a market correction. It is possible the two swift stock market sell-offs and recoveries over the last 12 months were all that was needed but the earnings picture has not improved suggesting a repeat is likely.

Talk of a Fed rate hike later this year (after the election) has pressured bond prices as well as gold. After a very strong rally earlier this year gold has corrected over 8%. Real estate and utilities have also been hit by potential rate hikes.

European stocks are starting to waver again but Asia and Latin America regions have been able to maintain the uptrends they started around the start of the year.

On the bond side of the market, the biggest surprise might be how well corporate junk bonds have held up. The recovery in crude oil prices appears to have taken some of the pressure off the highly leveraged energy market.

We have definitely seen a change in market character as we transitioned from summer to fall. To give you an idea here is how some asset classes have performed over the last 90 days.

90dayAssetClassPerf

The market appears to be telling us interest rates are going to adjust up which has caused most bonds, gold and real estate to fall after being darlings earlier this year, especially gold and real estate.

Money is still being put to work in high-growth stocks and markets which explains why the Nasdaq 100 and most emerging markets are outperforming developed market large-cap stocks. Also, in Europe and Japan central bank policy remains more active (although Japan has stepped back a bit), where stocks are still responding favorably.

What we are experiencing is a classic adjustment period where markets are taking into consideration the impact of higher interest rates on the short end of the yield curve and the potential impact to longer bond maturities.

Exposure to high-growth mid-large cap U.S. and emerging markets stocks has helped maintain portfolio value over the last few months. So far shorter maturity bonds have only experienced small declines but further weakness might indicate a market that expects the economic recovery to accelerate with more rate hikes to follow. Don’t count on it, there is sparse data suggesting anything of the sort.

As I have said before, margin debt is the one area where higher rates could aggravate stocks. Margin debt peaked 18 months ago so it is entirely possible the next ramp up on stock prices will be a function of levering up again assuming the costs are not prohibitive – we are likely a long way from that problem. Who really thinks 3-month T-bill rates will normalize at 2.6% anytime soon?

There are plenty of strategies for positioning your retirement assets in this market for long-term growth or a margin of safety. Let me know if this is a subject you would like to discuss in more detail.