A Change In Equity Market Leadership Is A Positive

One favorable aspect of the current equity market is the broader favorable performance across a wider range of asset classes and investment styles. I wrote about this in mid September last year and at the time raised the question whether this rotation or change in leadership had more room to run. The below chart clearly shows that a shift in leadership has carried through the first quarter of this year. The blue line on the chart represents the average total return of the six stocks, Facebook (FB), Amazon (AMZN), Netflix (NFLX), Google (GOOGL), Microsoft (MSFT) and Apple (AAPL). Collectively, these six stocks are trailing in performance relative to the other asset classes shown. Up until September though, the asset class returns were essentially reversed as seen in the second chart.

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Interest Rates Pressuring Bond Returns

It is not uncommon for the yield curve to steepen as the economy exits a recession and transitions into expansion mode. After another Fed induced yield curve inversion in August of 2019, the economy dipped into a recession at the end of 2020. Certainly the pandemic shutdown contributed to the recession, but possibly the economy was headed in that direction anyway following the yield curve inversion.

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Negative Interest Rates And The Impact On Investor Investment Choices

One phenomenon investors face today is the fact central banks around the world have moved to a negative interest rate posture. Earlier this month Federal Reserve Chairman, Jerome Powell, stated the U.S. Federal Reserve is not considering moving the Fed Funds Rate to a negative level though. Yet, rates in the U.S. are near zero with the Fed Funds target rate at .25% or 25 basis points. A one month U.S. Treasury Bill yields just under 13 basis points. In other words, rates are near zero and going to a negative level is not out of the realm of possibility. One recent article notes if the Fed does push rates to a negative level it will do so in a meaningful way, maybe as low as minus 100 basis points or minus one full percentage point. What are the implications of negative rates if this were to be realized?

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The Yield Curve Dominates The Narrative

On Wednesday the financial media would have one believe the world and market's would fall apart as a result of the 2-year/10-year U.S. Treasury yield curve inverting, i.e., the 2-year yield moved to a higher level than the 10-year yield. The S&P 500 Index fell 2.93% on the day. The importance of the inversion is the fact the yield curve has some predictive power in recession forecasting. From a technical perspective though, the yield curve inverted on an intra-day basis but not on a closing basis. At the close Wednesday, the curve was positive, even if only by 1 basis point and has since steepened to 7 basis points.

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Increasing Bullish Equity Sentiment And Declining Bond Prices

As of Wednesday's market close, the S&P 500 Index is up 11% on a year to date basis, while most bond strategies have struggled to breakeven at best. Longer term bonds have been the most challenged as evidenced in the below chart. The iShares 20+ year Treasury Bond ETF (TLT) is down 7.7% year to date. Through Wednesday's close, the 30-year U.S. Treasury is down 11.1% year to date. Of course, as interest rates rise, longer term bonds tend to be the least favorable bond investment as prices move inversely to the move in bond yields.

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Bond Yield To Stock Yield Spread Sufficiently Wide To Challenge Stock Returns

A little over a year ago I noted the yield on the 10-year Treasury surpassed the dividend yield of the S&P 500 Index. With rising bond yields, there becomes a point when the bond yield is sufficiently high relative to the yield on stocks that bonds can challenge stock returns. In that earlier article I referenced a research article written by CFRA Research's Sam Stovall and titled, Rising Prices, Shrinking Yields. In the research article it was noted prospective stock returns became most challenged when the yield on the 10-year U.S. Treasury exceeded the dividend yield of the S&P 500 Index by at least one full percentage point, i.e. 100 basis points. The forward return at varying spreads is detailed below.

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Higher Bond Yields A Headwind For Technology Stocks

In a recent note from the John Murphy of the stockcharts.com website ($$) he notes technology stocks tend to have an inverse relationship to bond yields. In his commentary he noted,

• "One of the lesser known intermarket principles is the inverse link between bond yields and technology stocks' relative performance...Growth stocks like technology...do better in a slower economy which is usually associated with low interest rates."

• "Value stocks (like banks) do better in a stronger economy with rising bond yields...Rising global bond yields could make the going tougher for technology stocks."

The below chart was included with his comment and shows the inverse relationship between the 10-Year Treasury yield (red line) to a ratio of the Technology SPDR (XLK) divided by the S&P 500 Index. Jon Murphy notes, "Rising rates this past month may again be contributing to tech selling, especially with a more hawkish sounding Fed. The inflationary impact of rising energy prices may also give the Fed more cover for a December rate hike."

Weakness is beginning to show in some of the large cap technology stocks. Below is a chart of the average return of Apple, Alphabet and Amazon for month to date in September. This time period is a short three weeks, but the performance of large cap technology stocks is something investors will want to follow as the last three months of the year unfold.

Disclosure: Firm/family long AAPL, GOOGL

Stocks Need Some Healthy Competition

It seems a day does not go by where various strategists lament the market's valuation and lack of any significant pullback in over a year and a half. Not only are the valuations of a number of equity indices above their long term average, some might say the valuations are indicative of the speculative froth in the market. One data point highlighted is the margin debt level. Certainly margin debt has increased as can be seen in the first chart below. However, the second chart shows that margin debt as a percentage of total equity market capitalization has remained fairly stable since 2010. A good article on evaluating margin debt can be found in a MarketWatch article from a few years back, Cash vs. margin debt is the real problem for this market.

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Investor Fund Flows Favoring Bonds And Not Equities

The equity market has gone over a year without a pullback of at least 5% or more. The last 5% decline occurred in mid-June 2016 when, over a two week period, the market fell 5.5%. Even in the run up to the election last year, the equity market did not close down over 5%. This lack of volatility is showing up in popular volatility measures like the VIX, but the VIX may not be a good measure of expected future volatility.  Also, this lower level of volatility has some strategists suggesting investor's have become to complacent about the equity market and have willingly taken on more equity exposure as a result.

A recent post by Dr. Ed Yardeni, Ph.D., and he puts out some great research, noted individual investors may have become too optimistic as well. In that post, Investors Hearing Call of the Wild, he included the below chart of U.S. equity ETF flows.

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The S&P 500 Index Is Expensive And Has Mostly Been So Since The Early 1990's

One can cite any number of stock valuation measures and conclude U.S. equities look expensive or are at least trading above their long term average valuation measures. In this environment one might conclude stocks are priced for perfection with little margin for error. Of course this might certainly be the case, but is this an uncommon position for the equity market? As the shaded areas in the below chart show, investors would have had a difficult time buying or holding onto stocks at valuation levels that were below their long term average valuation since the early 1990s.

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The Significance Of The S&P 500 Yield Falling Below The 10-Year Treasury Yield

For most of 2016 the dividend yield on the S&P 500 Index was greater than the yield on the 10-year U.S. Treasury. Historically, this has served as a positive sign for forward stock price returns. With the strong equity market returns in 2016 and the move higher since the election, the S&P 500 yield is now lower than the 10-year Treasury. In addition to the move higher in stocks, bond prices have declined as well (a higher yield) resulting in bonds now having a higher yield than the S&P 500 Index.

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Investors Adjusting Investments As A Result Of The Election Outcome

This post is more of a chartfest to feature information I ran across over the weekend from various sources but related to investment topics relevant to potential policy changes under a President-Elect Trump administration. Investors know the equity market reacted favorably to the election outcome last week; however, some market segments did far better than others. Although the night is long, the futures market tonight is indicating a positive open for Monday. The Dow and S&P futures are higher by about .40% to .50% (this is 95 points on the Dow.)

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Defensive Market Sectors Not So Defensive During Equity Market Pullback

With today's market close the S&P 500 Index has been down for nine consecutive trading days. The index is down 4.2% from the August 15 high, but remains up 4.1% year to date. However, during the pullback from the August high, most of the traditionally defensive sectors have been the worst performing ones. As can been seen in the below bar chart, REITs are down 11.1%, health care is down 10.9%, telecoms down 10.8% and consumer staples are down 5.5%.

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Bonds And Bond-Like Equities Adjusting To Higher Interest Rate Environment

The Federal Reserve meets during the first week of November to decide whether or not to increase interest rates. The probability of a rate hike in November stands at only 8.8% while increasing to 63.3% at the December meeting. With the elevated likelihood of an interest rate hike before year end, income focused investments, both fixed income and bond like equities, are adjusting to this potential outcome.

As can be seen in the above chart, over the last three months, the yield on the 10-year Treasury has increased over 30 basis points while a few selected income focused ETFs are down five percent or more, with REITs (IYR) down 10%.

The same return outcome is occurring with some fixed income investments. As the below chart also shows, bond investments are adjusting to a potentially higher interest rate environment as well. Longer term bonds, as represented by the iShares 20+ Year Treasury ETF (TLT), have fared worse than bonds of a shorter maturity and is down over 7%.

A Fed rate increase before year end is not a certainty; however, with market rates adjusting to a higher level, bond like equities and longer term bonds remain under pressure.

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.

Source: LPL Financial Research

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Junk Bond Risk Leading To A Potential 'Blood In The Streets' Environment

Investor attention at the end of last week's trading was focused on the sharp sell off in high yield bonds, better know as junk bonds. This sell off was precipitated by the firm, Third Avenue, restricting redemptions on its Focused Credit Fund. Subsequent to Third Avenue's announcement, Stone Lion Capital Partners L.P. said it suspended redemptions in its credit hedge funds due to the high level of redemption requests it has received. Many stories have been written about the events impacting the high yield bond market, here and here. 

In reality, a better classification for the Third Avenue Focused Credit Fund is probably a distressed debt fund or special situation fund. The fund's "focused credit" reference means just that, the fund is highly concentrated with nearly 30% of the fund's assets invested in its top 10 bond holdings. In other words, the fund is not a diversified bond fund. Our clients know we eliminated our high yield bond exposure in July of 2014. One reason we sold the high yield exposure last year was due to the narrow spreads on high yield broadly as reflected by the red dot in the below chart. This tight spread characteristic is an indication of the rich valuation of the high yield asset class at that time.

From The Blog of HORAN Capital Advisors

The issues surrounding high yield are being felt in the equity market as high yield bonds and stocks are highly correlated. Last week the Nasdaq declined 4.1% with the S&P 500 Index and the Dow Jones Industrial Average both declining 3.8% and 3.3%, respectively. For the year both the Dow and S&P 500 Index are essentially flat for the year on a total return basis while the Nasdaq remains up a little over 4.0% year to date. On a price only basis the S&P 500 Index is down 5.6% from its high in May.

The pullback last week has resulted in the CBOE Equity Put Call Ratio spiking higher to .92 as can be seen in the chart below. As I have noted in earlier posts, P/C ratios over 1.0 are representative of an oversold market. The second chart shows the VIX index and this fear measure has also jumped higher to 24.4. Readers can track these fear measures here.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

One near term concern we discussed in a mid-November post was the fact the On Balance Volume indicator (OBV) continued to show more trading volume on down days than on up days. This has been the case all year and has resulted in a downward sloping trend for the OBV a noted by the second white line in the below chart. From a positive perspective some technical indicators are beginning to look more favorable (CBOE P/C ratio noted earlier), but also indicators like the Full Stochastic Indicator below.

From The Blog of HORAN Capital Advisors

The risk developing in the junk bond market is a consequence of the Fed's extended near zero interest rate policy and investors feeling the need to reach for yield. Similar challenges have developed in the energy Master Limited Partnership (MLP) space. The belief is the Fed desires to begin removing the proverbial bunch bowl and raise interest rates at the conclusion of next week's Fed meeting. I suppose it is possible the recent issues facing the bond market could result in the rate increase being pushed into early next year.

Many of the headlines over the weekend were bearish ones with valid concerns about the high yield bond issues spreading into other areas of the market. On the other hand, this week's Barron's cover story highlighted 2016 forecast by ten strategists and all ten predicted higher equity returns for next year, with the average equaling 10%. With the issues facing the high yield bond market and a potential Fed rate hike around the corner, higher volatility in equities could face investors as the year nears its end. If this volatility is on the downside, Baron Rothschild, a member of the Rothschild banking family, is created with saying, "Buy when there’s blood in the streets, even if the blood is your own."

A Fed Rate Increase May Be Larger Headwind For Short Maturity Bonds

Whether the Fed raises rates in December or early in 2016, many market strategists believe higher interest rates will be a reality very soon. A few of our recent articles mentioned our belief that the Fed missed the opportunity to raise rates twelve or eighteen months ago and a rate rise now will be implemented simply in order to provide the Fed with a cushion in the event additional stimulus were needed. Certainly the Fed has used other extraordinary means in an effort to stimulate the economy other than rate adjustments over the last few years.

Nonetheless, the anticipated change in Fed policy to one where rates begin to move higher can have short term negative consequences for bond investors as we have written recently. All bonds will not react the same as rates are increased though. Logically if would seem the largest negative impact will be felt at the long end of the yield curve; however, the below chart compares the yield curve shifts over the last several years. What is occurring is longer rates are actually declining with rates on the short end, under five years, increasing. In other words, the curve is flattening with the twist occurring around the five year maturity range resulting in poorer total return for shorter maturity bonds than longer ones.

From The Blog of HORAN Capital Advisors

Certainly rising rates can have an impact on long rates; however, another key variable is the level of inflation. What the economy has not seen during this recovery is a move to higher inflation. On the contrary, with the contraction in energy and commodity prices, along with a stronger U.S. Dollar, inflation has remained near zero as can be seen with the red line in the below chart.

From The Blog of HORAN Capital Advisors

A potential catalyst to increased inflation is the fact consumer wage growth has been accelerating over the past three years despite what gets reported in the media. Since the consumer accounts for about 70% of economic activity in the U.S., higher wages can result in more buying pressure and thus the potential for higher selling prices on goods and services. Additionally, consumers are getting an indirect boost in their income as a result of the contraction in energy prices. Consumers are paying less for gasoline and utilities, leaving more income available to be spent on discretionary purchases. In addition to a strong U.S. Dollar, the increased efficiency being created by the internet and cloud via growth in e-commerce seems to be keeping a lid on price inflation. The end result near term is the worst performing segment of the bond market in terms of maturity may be on short term bonds versus the long term ones.

Low Bond Yields Heighten Bond Return Risk When Rates Rise

Although the rate of interest currently paid on high quality bonds today is at levels last seen in the early 1950's, investors generally allocate a portion of their investment portfolio to bonds. One reason for having a portion of an investment portfolio in bonds is the fact bonds tend to hold up well when equity prices decline. Proof of this can be seen in the below chart comparing various stock returns to different bond category returns during the financial crisis. During the worst of the financial crisis that began in October 2007, U.S. stocks fell 56.8% while the Barclay's Aggregate Bond Index and Barclay's U.S. Treasury Bond Index were up 7.2% and 15.4% respectively.

From The Blog of HORAN Capital Advisors

Source: Vanguard

One near certainty is the Fed will increase interest at some point with it simply a question of when not if. When interest rates are moved higher (some believe a December liftoff), bond prices will decline and bond investors may be in for a bit of a surprise. A unique characteristic facing investors today is the rate of interest paid on high quality bonds is at extremely low levels. Historically, bond investors obtained some support when rates increased due to the income support provided by bonds. The below chart from Nuveen highlights the high percentage contribution to return that income has provided to overall bond returns since the end of the financial crisis and since 1976.

From The Blog of HORAN Capital Advisors

Source: Nuveen

The below table from Vanguard is maybe a bit dramatic, but the table shows the impact on a bond's price return given a three percentage point increase in interest rates. One takeaway from the table is the amount of time it takes to recover the principal loss through the interest payment: over three years. This extended recovery is a result of the low interest rate starting point, 2.1% in the example and not far from today's rate.

From The Blog of HORAN Capital Advisors

Source: Vanguard

T. Rowe Price recently opined on this same issue in a recent report. The firm notes,

"Rising rates generally result in principal declines in bond securities, and that risk is exacerbated with rates so low because investors have less of a yield cushion to offset price declines. Overall, though, the firm concluded that "since 1979, bonds have generally not done well during tightening cycles." In fact, that has been the pattern in every tightening cycle since 1963." 

"In the last Fed tightening cycle from 2004–2006, when the Fed rate increased from a multi-decade low of 1.00% to 5.25%, longer-term yields barely budged. This cycle, T. Rowe Price managers expect the bulk of future rate increases to unfold in the short- to intermediate term bond sectors, causing a flattening in the Treasury yield curve (with short term rates rising more than long rates). 'I expect rates to stay fairly low even after the Fed starts raising them,' Mr. Huber says. 'Longer-term rates should stay under control because they are driven by inflation and global growth expectations, which are very modest.'" 

Mr. McGuirk adds, "We don’t see any big move in long rates, and with the Fed moving gradually, you have a long time to earn the extra income to offset any principal loss."

One way to shorten the time period it takes to recover the principal loss is to invest in bond's with higher coupon yields. However, given the extended length of time the Fed has kept rates at the near zero level, higher yielding bond supply is down significantly. As can be seen in the below chart, the percent of bonds that yield more than 4% is far below what was available prior to the onset of the financial crisis.

From The Blog of HORAN Capital Advisors

Source: Blackrock

For investors, the low level of interest rates does pose a potentially higher risk to overall bond returns when the Fed does commence with a higher rate policy. The silver lining is the fact the Fed is most likely to move slowly while pushing rates higher and in small increments. A low trajectory in the rate increases reduces the downside that results from a decline in a bond's price. And lastly, as noted in the above T. Rowe Price highlight, with the low level of inflation and slow global economic growth, the longer end of the interest rate curve may increase at a much lower pace than the short end. And it is long term bonds that can experience the largest price declines when rates rise.

Fed Rate Decision More About The Economy Than The Rate Itself

Probably the most discussed potential Fed decision on rates is the one forthcoming on Thursday. When it is all said and done, the rate increase in and of itself is really not the issue investors should factor into their investment decision. As we have pointed out in prior posts, higher rates have mostly been a positive for stock returns. A primary issue is the state of the economy, both in the U.S. and globally and the tightening impact of a rate increase. Compounding the confusion around the impending rate increase or no increase, is the uncharted territory created by all of the Fed's quantitative easing activities implemented since the end of the financial crisis.

In reality, a quarter percent (25 basis points) increase from a near zero rate is likely to have no material impact on many fronts. The pace at which the tightening is pursued though is an issue. The other is the fact the Fed states rate decisions will be data dependent going forward. Therein lies the market's confusion. The Fed has a 2% inflation target which has yet to be reached and it is debatable if the economy is near full employment given the sharp decline in the participation rate. A case can be made that the last QE program was not needed and a tightening cycle should have been started over a year ago. In reality, at the end of QE3 the Fed made clear it would retain bonds purchased under the QE programs, would also reinvest bond proceeds and rates would remain near zero for a "considerable time." All of these are easing activities. This brings us to the decision on Thursday and the data that outlines economic activity.

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Rising Interest Rates Historically A Positive For Equity Returns

The upcoming two day Federal Reserve meeting that concludes September 17th seems to have investors on edge. The million dollar questions is whether the Fed will raise rates or not. If one is a stock investor, they should hope the Fed raises rates and puts this extended anticipation to rest. Another reason investors may want to see the Fed raise rates is due to the positive impact a rate increase has on equity prices.

As we noted in a post last month, Anticipating The Rate Hike, initial Fed rate increases tend to not have a negative impact on equity prices. Further evidence can be seen in the below chart. The red dots on the S&P 500 Index chart line denote the first rate hike in a Fed tightening cycle. The yellow line represents the yield curve (30 yr treasury minus 3 month treasury bill) and one can see why investors focus on equity performance when the yield curve inverts.

From The Blog of HORAN Capital Advisors

As the red dots clearly show, the onset of a tightening cycle isn't necessarily a precursor to poor equity market performance. In our earlier article link above, we provide a magnified look at equity market performance around this initial rate hike period. Equities do tend to exhibit weakness initially; however, the weakness tends to be short lived.

S&P Dow Jones Indices recently released a report, What Rising Rates Will Not Do, that also examined equity returns in rising interest rate environments. The below chart included in the report shows the S&P 500 Index return during rising rate periods. The shaded area represents rising 10 year yields and clearly a rising 10-year treasury yield has not been a negative for stock returns.

From The Blog of HORAN Capital Advisors

Source: S&P Dow Jones Indices

Breaking down returns by month, S&P notes,

"Furthermore, between January 1991 and June 2015, the average monthly return for the S&P 500 was 0.88%. Paradoxically, in the four periods of rising rates, the average monthly return was 1.26%, compared with an average monthly return of 0.73% for the periods of declining rates. Rising rates have clearly not been bad for stocks over the past two decades (emphasis added.)"

For more insight into equity returns during these tightening cycles, our article a few years back, Rising Interest Rates Can Be Good For Stocks, provides a table outlining equity returns over various cycles going back to 1973. It seems the Fed has missed an opportunity to increase rates as far back as a year ago; however, a lift off in September doesn't mean stocks are a poor investment over a complete tightening rate cycle. Certainly, stocks are likely to experience more volatility around this initial lift off period, but can move higher after the beginning of the rate increase cycle.