In the wake of Hurricane Michael’s devastating blow to the Florida panhandle, I took some time to look back over the indicators that I track (for the stock market, not the weather). The first half of this month has been a rough one for stocks and bonds both, with the S&P 500 down about 4.7% (as of the close on 10/10/18) and the Bloomberg Barclays US Aggregate Bond Index down about 0.38%. Despite this, the S&P 500 Index is still up about 5.64% year-to-date, while bonds are down about 2.5% for 2018. For certain, there has been a bit of a rotation recently. Technology has given up leadership, and healthcare has taken over. Retail is still losing strength, but utilities and consumer staples have gained strength. It’s odd that these defensive sectors are gaining strength despite the recent rise in interest rates, as higher dividend-yielding stocks often do not like higher interest rates.
A month or so ago, there was a lot of concern about the yield curve inverting. It never did invert, and the recent sell-off in bonds has caused the curve to look more normal, with longer-term rates being pushed back up. This is important to investors of both stocks and bonds because many times, an inverted yield curve predicts a recession. Its reliability is very high. Today, though, the curve is fairly normal looking, although a bit flatter than we might prefer. The difference between 2-year bonds and 10-year bonds isn’t much, indicating that investors may be concerned that economic conditions favor current growth, but not future growth.
Unfortunately, rising interest rates has pushed money out of stocks, particularly the aggressive technology stocks that did so well up until a month or so ago. It is my opinion that this is the reason that the stock market has dropped recently, because bonds are becoming better alternatives. I think particularly of pension funds that have to manage cash flows for retirees. Uncertainty is their enemy, but over the past few years, they’ve probably been buying more stocks than they are comfortable with, since bonds yielded so little. However, today, with a 10-year Treasury bond yielding around 3.2% (last year it was only yielding about 2.3%, so the yield is up nearly 1.5 times), pension funds might be willing to take the profits they’ve made in stocks and decrease their uncertainty a bit by buying bonds. On top of that, there are probably some margin calls. Investors might be forced to sell off their stock positions to meet these margin calls, causing a piling on effect on stock prices. A similar thing happened in February, you may recall. Back then, the 10-year Treasury bond was trying to get above 3%, and stock investors were reacting to that. It took a few days to adjust, but we did, and the reality of favorable market conditions set back in, and stocks resumed their march higher.
I don’t think either of these (interest rates and margin calls) are economic events, at least not yet. Earnings season for companies starts to ramp up tomorrow, and I think most companies will have very good reports. Railcar activity is very good, there’s plenty of liquidity, and the jobless claims numbers are fantastic. I believe that the most reliable predictor of stock prices is corporate earnings, and as long as that number is projected to rise, the stock market should be okay. However, there is the reality that interest rates are higher, machining bonds a more compelling investment, meaning that earnings will have to be particularly good to keep investors from taking their profits and moving to bonds. I don’t think that this is occurring now, but, like watching for an oncoming hurricane, we’re paying attention to the charts for what direction trouble might be coming from. Like with bad weather, it’s better to be prepared early, not otherwise.
As always, these opinions are mine, and may or may not be the same as those of Raymond James. This is not a solicitation to invest, although we do invite you to give us a call to review your portfolio with us to see if any changes should be made.