July 25, 2017
Dow Jones Average: 21,513
S&P 500 Index: 2,470
A (Bond) Market’s Mindset
In our last strategy update we wrote about how the stock market processes and filters political and economic news. We highlighted what drives markets higher, namely economic conditions and earnings growth. We also outlined the historically disruptive and disastrous events for investors, recessions and asset bubbles. Most other daily headlines are rightfully ignored by the stock market as noise. The bond market processes the same information and these two markets together can be seen, at any given moment, as mirroring the country’s and world’s future economic prospects. Signals from the stock and bond market typically reflect a similar and unified outlook for the economy. However, every once in awhile they disagree, and it serves investors well to take note of this dissonance. As events played out in the second quarter of the year, we approached one of those moments of discord.
To understand the bond market and the message it carries, one must understand the yield curve. Bond investors are lenders and typically lenders require more rewarding rates of return the longer they lend their money. Most people prefer the certainty of cash in hand or under the proverbial mattress. When one gives up the opportunity to spend cash in the present or keep it under the metaphorical mattress, a rate of interest is usually required on the money lent. The rate of interest investors require for a 2-year loan is normally a lot less than the rate of interest required for a 10-year loan. The interest rates on the spectrum of bonds, or loans, create the yield curve. This curve typically slopes upward, with higher interest rates demanded for longer bonds. In a strong economy there is a lot of demand for money and expectations are that inflation will rise. Lenders can in turn demand high rates of interest in exchange for tying their funds up for years down the road. These conditions existed most recently in late 2009 and 2010. Bond investors could earn nearly 3% more by investing in a 10-year US Treasury bond than in a 2-year Treasury bond. The yield curve was steep and the bond market offered a very rosy economic picture. Stock investors were still feeling a bit wary after the recent financial crisis. It took them longer to become so optimistic, but that was the beginning of the bull market for stocks that continues today seven years later.
When the yield curve flattens and long-term bonds carry less of a premium interest rate, it signals economic trouble ahead. This can indicate a variety of things, that bond investors are less concerned with inflation, that they think the Federal Reserve will start to lower rates, or that investors in general are more risk averse. Whatever the underlying motivations they almost all point to muted expectations for the economy or even fears of a recession. There are even moments when the yield curve inverts and the psychology of a lender outlined above is turned on its head. In the last fifty years these moments of bond inversion have been the clearest and most accurate predictor of economic gloom. It last occurred in 2006, a little more than a year before the US officially entered a recession.
Today the yield curve is starting to bring to mind 2006 more than 2010 for bond investors. The Federal Reserve has raised rates three times in eighteen months and has a stated goal of doing so four more times in the next eighteen months. The bond market is anticipating this and short-term rates are much higher than they were just a year ago. What should be worrying to investors in all markets is that right now interest rates on long-term bonds have not followed short-term rates higher. The yield curve is flattening and the bond market is sending a signal of concern about the economy. The 3% premium a bond investor could get from lending their money on longer terms back in 2010 has now fallen to less than 1%. The bond market is rightly considered by most observers to be the wiser, reasoned cousin of the impetuous and emotional stock market. Often they agree in their collective assessment of the economy’s prospects, but when they strongly disagree long-term investors would do well to listen to the message coming from the bond market. In 2017 the stock market set successive new highs on a regular basis and rich stock valuations are now predicated on an outlook of robust earnings growth in the years to come. The bond market has become flatter, and in so doing, it is sending a more pessimistic message about the growth of the economy. This contradiction is becoming more pronounced and calls into real question the ongoing strength of this bull market in stocks.
The concern we speak to above could take many months or quarters to materialize, if it does at all. In the near term, the stock market has been quite strong and is setting new highs on a straight and seemingly reliable trajectory. Investors are conditioned to buy into any dips in the broad market, and seem so keen to do so that dips have nearly disappeared in the last year. It has been a rewarding and comfortable time to be a stock investor. While the economy has not accelerated higher and consensus around comprehensive fiscal stimulus has not materialized, investors have instead simply gravitated back to the themes that were working before the new administration entered office. The powerful technology companies continue to carry this market higher. The technology-heavy Nasdaq Index has nearly doubled the performance of the broader indices so far this year.
Our mix of investments fared well in the second quarter, building on gains posted in the first quarter of the year. We continue to find companies that are attractive investments, and just as often we find existing investments that have run their course in part or in full. The buys and sales we have made through the year have left many clients at a similar investment position that is slightly conservative in our view. With some foreboding clouds on the distant horizon it is dangerous to assume it will never rain. However, it is also unrewarding as an investor to head inside too early, as the clouds may just blow away. We are doing our best in this environment to put each client in front of compelling long-term investments, while also carefully controlling their exposure to a lofty market that may soon be overextended.
We took advantage of the rising short-term interest rates noted above. The Federal Reserve raised rates again in June, and for many clients we bought a series of short-term Treasury notes that extend out between six months and one year. These bonds yield about 1.2% and they offer the flexibility to move into other stock or bond investments at a moment’s notice. If no such opportunities materialize, then we can rotate them into similar replacements when these mature. At a time when many money market fund operators are retaining yields in the form of their fees, we believe direct purchases of short-term treasury bonds are the best way to ensure that the benefit of rising interest rates accrue to our clients.