Tuesday, August 16, 2016

Should Investors Worry More About A Bond Or Stock Market Correction?

A great deal of commentary over the past few days has focused on the recent equity market trifecta, i.e., the Dow Jones Industrial Average, the S&P 500 Index and the Nasdaq Composite Index all hit new all time highs on the same day and the heightened potential for an equity market correction. Over the past week or so, LPL Financial Research has published some good analysis around the broad index participation in new highs and potential future market outcomes. Since 1980 12-month rolling returns have been positive 76.5% of the time. As the below table shows, when the Dow, S&P 500 and Nasdaq hit all time highs on the same day, the 12-month forward return is positive 75% of the time and averages 11.9%. I would recommend readers read the LPL article.

Equities have certainly had a nice move to the upside following the February market lows. And given the strength of this move, some downside consolidation would be expected. However, simply because the three indexes hit new all time highs, this does not mean stocks are necessarily due for a correction.

What investors might not be focused on though is the strength in fixed income returns this year. As the year got underway, market expectations were the Fed could raise the Fed Funds rate up to as many as four times over the course of 2016. Now, if we get one rate increase, that might be all the market will need to digest in 2016. As a result of this lower trajectory in potential rate increases, fixed income returns have far exceeded many investors' expectations. The below chart clearly shows the strength of a select few fixed income vehicles along with the S&P 500 Index.

The S&P 500 Index year to date return has trailed the return of the long term Treasury Index and high yield index. Additionally, with these strong returns in a number of fixed income categories, should investors be more concerned about future bond returns than future stock returns? The iShares High Yield Bond Index (HYG) has hit a record high and the 30-year Treasury yield is near a record low and I am only showing a couple of examples.

For investors, if one year forward corporate earnings meet expectations, this could be one tailwind for stocks. We have discussed this in several earlier posts along with the fact economic data is largely coming in better than expected, not only in the U.S. but in Europe as well. Some of these variables suggest there is greater potential downside risk in some bond categories and the stars may be aligning for further upside in stocks over the next twelve months. Higher equity prices certainly will not unfold in a straight line though.

Update (8/17/2016-2:35pm): One reader suggested we refer our readers to the following link (WHAT GOES UP…) which contains a counter perspective to the LPL piece. I think it is an interesting viewpoint that is worthwhile for readers.

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