When economic conditions are deemed to be benign or favorable, investors will often get aggressive, placing very high values on future profits that may or may not materialize. Declining inflation and hopes for interest rate cuts buoyed stocks in the final two months of 2023, and that enthusiasm carried through the first quarter of 2024. After two years of sharp declines and subsequent rallies, the S&P 500 Index finally broke above its previous high watermark set in 2021. But now the entire rationale for the first quarter rally has been thrown into question as hotter inflation has reemerged and interest rates have risen accordingly. Just a few months ago most investors anticipated seven interest rate cuts in 2024 – the current expectation is for one or none.
The Federal Reserve has been hoping for that perfect mix of economic forces that tempers inflation to the two percent level, without pushing the economy into a recession. At the moment, they are still falling short of that first goal, as inflation has been holding steady above three percent and is more recently pushing back towards four percent. The job market is tight, boosting wages. While this is a good thing for most people, it complicates Fed policy by raising inflation. Exacerbating the challenge is a fundamental shortage of housing, which has kept prices elevated in many locations, despite higher mortgage rates. Housing costs are the single biggest input to the inflation indices, as housing is the biggest expense for most people. There is no sign that prices will moderate any time soon. With wages and housing prices working against the aims of the Federal Reserve, the central bank has altered its language in recent months and indicated that it will move more slowly than expected in lowering interest rates.
The level of interest rates has a big impact on the valuation of both stock and bond prices. Warren Buffett is quoted as saying “interest rates are to stock prices as gravity is to matter”. In other words, higher interest rates should exert a downward pull on stock prices. But that didn’t happen in the first quarter of 2024. Rates rose from a low point at year-end without denting the stock market rally. Investors shrugged off the interest rate rise and continued to believe that the Fed was still on the cusp of a rate-cutting campaign. Those hopes were finally dashed in April as more hot inflation data was released. Stocks began to fall, retreating some five percent. Gravity seemed to be taking hold.
Stocks, bonds and cash are always priced in competition with each other. Lower yields on cash and bonds encourages investors to put money into stocks, while higher yields on cash and bonds makes them more appealing to investors, creating an alternative to stocks. That is a simplistic, but generally accurate, outline of the forces that push trillions of dollars across these competing asset classes. The average dividend yield on stocks fell to a paltry 1.4% in the first quarter, as higher stock prices translated into lower dividend yields. Meanwhile, the yield on short-term Treasury bonds, considered the safest of investments, remained above 5%. That is a tough mathematical comparison for stocks, so it is not surprising that stock prices have retreated in recent weeks.
Current Strategy
The stock market rallied hard in the first quarter of 2024, spurred on by expectations of a big shift in Fed policy. Investors assumed that rate cuts would start in March and then occur regularly throughout 2024. But so far there have been no interest rate cuts. It appears that just the mention of possible interest rate cuts was enough to stoke a rally in stocks and bonds, creating a wealth effect as investors looked at higher account balances. This in turn led to more consumer spending, preventing inflation from falling to the Fed’s two percent target. The Fed has tied its own hands as it can’t lower rates in the face of renewed inflation. The shift in Fed policy was simply an illusion. It remains to be seen how a market rally based on an illusion unfolds during the remainder of 2024.
We did not find our preferred set-ups for stock purchases in the first quarter of the year. We did take some profits in the rally, in most cases trimming back on some large gainers as opposed to an outright sale of the whole position. And we continued to hold substantial portions of accounts in short- to intermediate-term bonds and money market funds. With bonds and cash yielding in the 4.5% to 5.25% area, depending on the maturity length of the paper, we felt that waiting for better stock buying opportunities made sense.
Bond yields are rising again on longer-dated maturities, making bonds an increasingly attractive alternative to cash. At some point interest rates will most likely fall, but maybe not in 2024 as previously expected. A recession or geopolitical events that hurt economic activity could trigger a rush to bonds. The exact catalyst for a drop in interest rates is hard to predict and could catch most investors by surprise. It is wise, in our opinion, to be in position with some intermediate-term bonds before such an event occurs. The opportunity to build a reliable, base return of about 4.5% to 5.25% per year for several years or more is currently available, but that may not always be the case.
