The stock market recovered most of its losses from the sharp, interest-rate related sell-off in early February. That said, the bounce appears to have stalled without having made new highs on a broad market basis (the NASDAQ did make an all-time high on March 13th). This is in spite of the fact that interest rates peaked in the third week of February. They have been falling lately as this month’s inflation numbers have not confirmed the stronger numbers from last month. See Figures 1 and 2 below. I am going to address how we currently feel about both that bond and stock markets in the near term, and what we are doing in portfolios.
Source: S&P 500, YCharts.com
Source: US 10 Year Treasury Note Yield, YCharts.com
- Reacted violently to strong economic reports all through the month of January and into the third week of February;
- Broke through their 2017 high points across the maturity spectrum;
- Threatened in the case of 10 and 30-year bonds to technically signal a conclusive breakout (ending the 30+ year bond bull market), but ultimately backed-off;
- Rallied on oversold conditions in the last week of February, gave up that rally, and are trying again to rally on some economic weakness (retail sales) and the possibility of a global economic slowdown tied to trade wars.
Given the terrible performance of bonds since the beginning of the year, the recent rally has been underwhelming to say the least. The 10-year note has to break back below 2.80% to signal that the near-term outlook is even neutral. A break back below the 2017 high yield of 2.64% would confirm the “goldilocks” market environment had returned and would probably be bullish for financial assets. High yield bonds have not performed well lately, which may not be a good sign for economic health overall. The same can be said for the rising LIBOR rate.
- Plunged to their 200-day moving average on February 9th;
- Rallied hard late that day and for the next week;
- Have been grinding their way sideways to higher over the last four weeks but remain well below their January 26th
- Volume and breadth during the rally period have not been as impressive as they were prior to January 26th, and VIX has remained north of 15 (higher than it was at ANY point in 2017).
Two thoughts. One, almost all long term technical indicators are bullish. There have been no major failures or breakdowns so far. Bull markets generally experience consolidation periods, and, given the strong performance of stocks in 2017 we were way overdue for one. Odds are, that is what we are going through now. On the other hand, the stock market typically never goes straight from bull to bear – there must be a peak, a decline, and a failed rally before things really get going on the downside. Because of the 10% sell-off last month, we now have the first two components (the peak and the decline) in place. If the current rally fails to lift the broad market to new highs, the technical implication would be that the February 9th intra-day low may need to be re-tested.
How We Are Positioning Now
Prior to January 26th most of the negative market news focused on the historically high current valuation. There was nothing fundamental or technical to suggest the market was at risk. To that end, the most I could muster was to say that economic and market conditions were as good as they could be and maybe therefore it made sense to take some profits before things changed. Today things have changed somewhat.
The common conditions that have killed past bull markets – rising interest rates, foolish trade policies, etc. are on the visible horizon. As such, more care is warranted now though I still believe that it would take several months of choppiness for the market to completely roll over. Typically, investors who have been very well rewarded by “buying-the-dip” don’t suddenly become rally sellers in three weeks.
That is all a prelude to say that we are increasing exposure to short term, medium quality debt at the expense of stocks and longer maturity debt. We touched on reducing interest rate exposure in our last report, so I won’t go over that again, but it’s worth a read. Modestly reducing stock exposure, both international and domestic, is a nod to the ideas that:
- Valuation may not matter in the short term, but eventually it does;
- Interest rates are probably at a point in the economic cycle where they are headed higher which is not a positive for corporate finances, and from here anything that would send interest rates meaningfully lower would probably also be very negative for stocks.
- We may be headed toward at a trade war. Historically, trade wars have decreased overall economic growth while increasing inflation.
- Central banks are beginning to “mop up” some of the excess liquidity they’ve provided to the markets for the last 6-9 years (depending on the central bank) via ultra-low interest rates and aggressive open market operations.
The bottom line for stock investors is this: Over the past nine years we’ve had just about all the good news one could hope for. However, easy credit, corporate tax reform, and a collegial global trading environment are now behind us. If corporate earnings don’t dramatically accelerate, what are the other potential upside catalysts? A little caution at the margin is warranted.
 The source for all bullet points is Telemet Orion
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