Here is our monthly view of the financial markets and some of the thoughts that go into our investment decisions.
In the last issue of this newsletter I made an observation that the stock market was seemingly ignoring a rise in interest rates. This week the market abruptly took notice. The 10-year US Treasury this week accelerated higher moving from 3.05% on Tuesday to 3.23% at the close of business on Friday. This broke the previous 2018 high of 3.12% set in mid-May. To many technical analysts, this represents a break-out and signals higher rates to come. The S&P 500 fell almost 40 points in two days. It does appear that the path of rates seems to be upward. For almost 40 years interest rates made a long succession of lower lows. On July 2016, the 10-year yield was 1.30%. Now we seem to be making higher highs in rates. It will be interesting to see how bond investors, if indeed rates will continue to rise, behave as their portfolio values decline. Recall that bond prices and rates move inverse to one another. Higher rates mean lower bond values. The Vanguard Total Bond Index Fund lost about 1% this week and is down 2.65% this year. The Vanguard Long-term Bond Index Fund is down almost 8% year-to-date. Market analysts used to talk about a “Great Rotation” meaning that when rates finally rise, investors will sell their bonds and buy stocks. I’m not hearing that anymore. I’m not sure why. Perhaps the increase in short-term rates – the 3-month Treasury bill now yields 2.2% means that investors will sell their bonds and go to either short-term notes, CDs or cash. A growing consensus should always be examined carefully. Momentum moves opinions and subsequently prices, too far in one direction. The mantra is for higher rates. While the US economy is running at a fine pace with GDP growth over 4% in the 2nd quarter. Europe seems to be slowing. Except for July, the European Purchasers Manager Index (PMI) has fallen in every month this year. Like Europe, China’s PMI has moved lower throughout 2018. In general, the Emerging Markets are experiencing similar trends. Can US growth continue at the same pace when the rest of the world seems to be slowing? If the answer is no, interest rates in the US may not rise as much as the growing consensus believes. A lot of economic data is to come over the next few weeks. The inflation reports are due next week. If recent wage increases and higher gasoline and oil prices begin to flow through into the inflation indices, there will be more upward pressure on interest rates. We have seen certain groups like FAANGs doing very well in 2018 while other sectors like Financials doing poorly. If interest rates continue to rise, we might see the performance gap between various sectors narrow. I’ve mentioned before that low interest rates make suspect business models work. Easy money and low cost of funds help growth. Low rates also boost valuation multiples so that companies with low or no earnings can enjoy high stock prices. Times may be changing.. — Ian Green, Pendragon Capital Management
Investors came back from summer vacation and after a shaky start to September, rallied the market to new highs. The buying has occurred despite serious concerns over US trade policy with Mexico and Canada and a series of tariffs imposed on and retaliated by China. Bull markets are said to “climb walls of worry” and as such, stock prices have moved higher. Whether the market will begin to care about tariffs and trade remains to be seen. History seems to tell us that trade barriers are harmful to economic growth. The stock market is trading at 17 times earnings so there is definitely an expectation of growth. Should impediments to trade dampen growth, stock prices would be vulnerable. In addition to trade, the market seems to have ignored the rise of interest rates this month. The 10-year Treasury yield is back above 3%. Recently, the market has had “tantrums” when the 10-year has moved above this level. So far this time, there is little mention of the 10-year in the financial news. The market news, however, has continued to report on the Federal Reserve increasing the very short-term rates. The Fed Open Market Committee meets this coming week and the expectation is that another 25 basis point hike is in the cards. So far, the longer-end of the yield curve has not responded to increases on the shorter part of the curve. This has led to a flat-ish term structure of interest rates. A flat curve is a disincentive to banks to lend. Something to watch. Will tariffs, higher short-term rates, and a flat yield curve slow profit growth and create the disappointment that hurts a high P/E market? Remains to be seen. I suspect the Federal Reserve is aware that they can’t push too hard. If the Fed announces they will hold off after this week or after the December meeting, the market will likely take that as very good news. At present, this is the not the likely case. It is not the consensus view. Returning to stocks, bull markets can have explosive moves to the upside. However, there is a precedent that these moves lead to significant declines. I ran a simple regression of the S&P500 with a two standard deviation band going back to 1982, the beginning of the series of modern bull and bear markets. As a general rule, a two standard deviation move above a long-term average is a starting point for bubble territory. In my simple study, 3,300 on the S&P500 marks this area. That’s about 13% from current levels. I’m not saying that the bull market is about to end. Bull markets can go much further. There is no magic formula. What is important is that investors increase their caution. It’s easy to get sucked into the assets that are rocketing in the later innings of a bull market. Cannabis stocks are flying. We’ve seen Bitcoin run up and down. Private companies like WeWork are raising capital at big valuations. This is not a time for investors to lose their heads. Discipline is always an important quality to have, especially now. — Ian Green, Pendragon Capital Management