The S&P 500 has added another 3.08% so far this month, lifting its year-to-date advance to 12.7%. The EAFE foreign stock index is up 2.4% on the month, dragging its 2016 return back into positive territory at 0.68%. The Barclays Aggregate Bond Index is down -0.07% December, but it still clings to a 1.75% gain on the year. Chart 1 and 2 illustrate month to date and year to date returns through 12/28, respectively.
Near Term Outlook
The Russell 2000 small cap index rose close to 20% from its November 3rd close to its December 9th high. It has been moving sideways in a tight range ever since. The S&P 400 Midcap Index tells the same story. This is a pretty impressive move basis on the belief that tax and regulatory policies are going to change after inauguration day (especially when you consider that stocks weren’t considered cheap back on November 3rd, and the 10 year Treasury bond is 75 basis points higher). Technically, there is no reason to think that the path of least resistance isn’t higher both in stock prices and bond yields. However, I have two concerns. (1) There has been very little in the way of profit taking during this rally. It could well be that sellers are holding off until 2017 on the belief that tax rates will be lower next year. For this reason, even though I think there are further gains ahead this year, I would be careful about buying right now. Pent-up selling may occur in early 2017 and might offer a buying opportunity. (2) Pension funds with mechanical year-end rebalancing strategies could be moving as much as $58 billion out of U.S. stocks (and into foreign stocks and U.S. bonds) in order to remain compliant with IPS asset allocation guidelines. If that comes to pass it may put further pressure on stocks.
Changes to Our Longer-Term Outlook
- We are no longer negative on municipal bonds relative to taxable bonds. Munis sold off sharply after the election on the twin fears of higher inflation and lower tax rates (which makes their tax-equivalent yield less competitive). At current prices, their outlook as a whole is now no worse than that of high grade corporate bonds.
- There is very little value in high yield bonds. BB spreads have declined to 264 basis points. The last time they were at that level was August 2014. The cyclical low was June 2014 at 243bps; the previous cyclical low was in May 2007 at 171bps. Spreads reached 1182 basis points in November 2008 and more recently 510bps in early February. One could make the argument that the riskier end of the junk bond market still could get cheap since the current 998 point spread on CCC rated bond is quite a bit higher that the 632 point spread back in July 2014.  On the other hand, cyclical lows are made when the economy appears to be on solid footing such that investors will sell their lower yielding (interest rate sensitive) bonds first. Ultimately, rising rates create recession fears which crush high yield bonds. We’ve already moved up 75 basis points. How many more before investors lose their nerve? Bank loans are also far less attractive – the average bank loan trades at 99.5 today with a call somewhere between 100 and 101.  People will continue to buy these bonds in the short run because they have performed very well, but you should know they are priced to provide very little upside regardless of how well the economy does.
- It is very hard to be positive about emerging markets right now. We had become fairly enthusiastic about emerging markets over the summer because in a slow growth, low interest rate environment most emerging markets would benefit from having a lower level of indebtedness and a higher level of growth than developed markets. The U.S. election has changed the picture greatly. The general consensus that U.S. growth and inflation has embarked on a multi-year upswing has caused the dollar to soar relative to other currencies over the past six weeks. Many EM countries have U.S. dollar-denominated debt, meaning that it has become much more expensive to service this debt now that the dollar is stronger. The more of a country’s money that goes toward debt service, the less there is to use in ways that would grow the economy. We will see economic contraction in many EM countries. I believe Turkey is vulnerable, as are many African and South American countries. China has been selling U.S. bonds frantically trying to keep the decline in the yuan gradual.
I do not believe trade war risk is priced into stocks. The market currently expects experienced businessmen like Wilbur Ross and Rex Tillerson to steer Trump away from his campaign promises to punish countries like China and Mexico. That may well happen. If it does not, however, stocks are going to do poorly, here and elsewhere. Trade war risk is a big reason that the stock market appeared to favor Hillary Clinton before the election. Keep this issue in the front of your mind because its “black swan” potential is considerable. As I said, it is not priced in; investors will ignore it unless, and until, they can no longer afford not to.
 As measured by iShares Core S&P ETF (Ticker: IVV), iShares MSCO EAFE (Ticker: EFA) and iShares Core US Aggregate Bond (Ticker: AGG). Source: YCharts.com
 As measured by iShares Russell 2000 (Ticker: IWM) Source: YCharts.com
 The Heisneberg “The (Pension) Grinch That Stole the Christmas Rally” (12/23/16). Source: Seekingalpha.com
 As measured by US High Yield BB Option Adjusted Spread and US High Yield CCC or below Option Adjusted spread. As of 12/22/16. Source: YCharts.com
 Heather Rupp (AdvisorShares)
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