Client Note July 2021

August 5, 2021

July saw another positive month for most US equities.  The S&P500 gained 2.3%, led by growth stocks.  Top sectors were technology, healthcare, and utilities.  A return to growth stocks by investors aided technology shares, while a decline in interest rates gave a lift to utilities.   Energy and value stocks were down on the month, alongside emerging market equities.  And finally, large cap stocks dramatically outperformed small cap stocks. Essentially, it’s a moderate investors market.  The riskiest areas, like small cap and emerging markets, after a stellar start to the year, have been very much sideways the past few months, while the broad indexes continue to grind upward.   Energy is similar in having had a dramatic beginning of the year and now, since early June has been consolidating.   I am optimistic that the areas that have been languishing the past few months are near the end of this consolidation and should see higher prices into the third quarter.

Bond prices have generally risen as interest rates have fallen.  Junk bonds were flat while higher quality bonds saw price gains.  Given the weaker small cap performance and junk bonds underperformance, markets appear in a slightly risk-off mode, even as the major stock indexes continue to climb.  This is generally reflective of the doubt regarding the continued rapid economic growth experienced over the past 12 months.  Riskier stock price stopped going up in March, bond yields peaked in May, and only recently we have gotten worse than expected economic data in a lower revision of Q2 GDP growth and a few misses in employment data.  PMI and ISM indicators are meeting and beating slightly, almost exclusively due to ‘prices paid’ factors.  Higher prices are a positive, even if selling a similar amount of product.

Inflation, on a year over year basis is running “hot”, posting a 5.4% (CPI June). CPI for May was 5%. July is expected to be 5.3%.  There are two key items to remember when looking at inflation data.  The US was only starting to come out of lockdowns last summer (case effects) and the federal government was sending checks to all households (direct stimulus), working and non-working.  This glut of cash has caused serious anomalies in the CPI figures.  Used car prices up almost 100%.  New cars up 7% and travel costs up substantially, from depressed levels.  Today, supply chains and businesses have re-opened to a large extent and there are no more checks forthcoming.  I expect inflation numbers to come down substantially for the remainder of the year, which should support bonds, dividend paying stocks and to a lesser extent, precious metals.

Looking ahead, I maintain my upward bias towards stock prices, with the caveat that we will likely see more volatility, 2-4% weekly variations perhaps.   Interest rates could ease further as economic data comes in slower and slower, as we have now passed the peak growth period.  The US economy will continue to expand, albeit more slowly.   If we could see mid- and small- cap stocks do some catching up, it would give me more confidence that financial markets have more room to the upside, but this has yet to take hold.

Adam Waszkowski, CFA

Advisory and Consulting Services offered through NAMCOA® (Naples Asset Management Company®, LLC). NAMCOA is a SEC Registered Investment Adviser. Information presented is for educational purposes only for a broad audience.  The information does not intend to make an offer or solicitation f​or the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. NAMCOA® has reasonable belief that this marketing does not include any false or material misleading statements or omissions of facts regarding services, investment, or client experience. NAMCOA® has reasonable belief that the content as a whole will not cause an untrue or misleading implication regarding the adviser’s services, investments or client experiences.  Please refer to our Firm Brochure (ADV2) for material risks disclosures. Performance of any specific investment advice should not be relied upon without knowledge of certain circumstances of market events, nature and timing of the investments and relevant constraints of the investment. NAMCOA® has presented information in a fair and balanced manner. The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass.  Any opinions, projections, or forward-looking statements expressed herein are solely those of author, may differ from the views or opinions expressed by other areas of the firm, and are only for general informational purposes as of the date indicated.  NAMCOA® may discuss and display, charts, graphs, formulas and stock picks which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. Consultation with a licensed financial professional is strongly suggested. Please remember that securities cannot be purchased, sold or traded via e-mail or voice message system.  For more information, please visit www.namcoa.com

Client Note May 2021

June 8, 2021

After a brief pullback in early May, the S&P500 continued is upward grind, managing to eke out a slight gain, .66%, for the month.  Foreign shares did much better with Europe up more than 4% on the month.  Precious metals were the big winners with gold up 7.6% and silver gaining 7.8%   Precious metals outpaced other commodities, which generally fell during May.  Lumber is almost 25% below its peak in early May.  After an initial rise, bond prices were flat as interest rates stabilized. 

We may be seeing the initial switch back to technology and small-cap stock outperformance after a few months of underperformance.  Technology shares fell sharply early in the month and despite a solid rebound ended down 1.2% on the month.  However, since mid-May, the value-over-growth meme that we have seen the past few months has begun to reverse.  Small stocks and tech have begun outpacing cyclicals/value.   I expect this to continue through the summer.   Stocks remain in an uptrend.  Technology and small companies are seeing prices revived; gold has caught back up to equities and interest rates have been easing.   Sentiment indicators have moved from short term negative to neutral.  For me, this means the market has room to move up as it climbs a ‘wall of worry’ regarding inflation.  Once no one is worried, and everyone has ‘bought in’, THEN we need to be concerned as there will be fewer buyers left to buy.

The main, seemingly only topic, in the news is inflation and the employment situation.  The current narrative is that inflation is being caused not only by supply chain issues, but also by wage pressures.  The idea behind wage pressures is that, if wages continue to climb, prices for goods and services will increase as well, resulting in inflation. 

There is littlereason to think that the pace of wage increases coming out of the recession will continue to climb at the current pace after this summer.   We still have more than 7 million fewer people working than at the end of 2020.   During the recession low wage areas like food service and hospitality bore the brunt of the layoffs.  As people leave unemployment benefits, their new wages will be very similar to the benefits they have been receiving.  Some may earn less.  We are now seeing the peak of wage gains and expectations.  Upward pressure will ease over the summer hiring season ends and bottlenecks dissipate.

The key idea is that wages and prices dropped dramatically and have now rebounded.  This base effect, comparing last year to this year is very substantial.  The error is assuming this pace of gain will continue. The rate of increase in employment, wages, inflation and possibly, earnings will likely level off and slow.  How stock prices react in that environment will be interesting.  Sustained higher stock prices due to low inflation/low interest rates, or will slower growth be seen as a risk to earnings and thus stock prices.

Adam Waszkowski, CFA

Advisory and Consulting Services offered through NAMCOA® (Naples Asset Management Company®, LLC ). NAMCOA is a SEC Registered Investment Adviser. Information presented is for educational purposes only for a broad audience.  The information does not intend to make an offer or solicitation f​or the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. NAMCOA® has reasonable belief that this marketing does not include any false or material misleading statements or omissions of facts regarding services, investment, or client experience. NAMCOA® has reasonable belief that the content as a whole will not cause an untrue or misleading implication regarding the adviser’s services, investments or client experiences.  Please refer to our Firm Brochure (ADV2) for material risks disclosures. Performance of any specific investment advice should not be relied upon without knowledge of certain circumstances of market events, nature and timing of the investments and relevant constraints of the investment. NAMCOA® has presented information in a fair and balanced manner. The opinions expressed herein are those of the firm and are subject to change without notice. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass.  Any opinions, projections, or forward-looking statements expressed herein are solely those of author, may differ from the views or opinions expressed by other areas of the firm, and are only for general informational purposes as of the date indicated.  NAMCOA® may discuss and display, charts, graphs, formulas and stock picks which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. Consultation with a licensed financial professional is strongly suggested. Please remember that securities cannot be purchased, sold or traded via e-mail or voice message system.  For more information, please visit www.namcoa.com

Client Note March 2021

April 13, 2021

The first quarter was marked by two distinct phases. The first phase was a continuation of markets climb from the late October early November lows which peaked in mid-February. The second phase was characterized by a distinct outperformance in value or cyclical areas of the market. This is the third instance in the past 16 months where we have seen value outperform growth.  Generally, this does not persist for more than a month or two.

The S&P 500 gained 5.5% during the first quarter while the aggregate bond index fell 3.7%.  Oil gained 26%, aiding the energy sector’s gains of 31% and gold fell by 10%    Corporate bond prices fell by 5.4%. Junk bond prices were unchanged.  This is a slightly odd relationship, but indicative of ‘risk-on’ alongside a rise in interest rates.   The gain in the general stock market and decline in bonds (and gold) left most balanced and multi-asset portfolios flat or in the low single digits.  With energy up, bonds and gold down, and seemingly only the largest companies are carrying the general stock indices higher.

Most recently, gold appears to have formed a “double bottom” in late March and has made slight gains. Stocks continue to grind up, but with the largest names leading.  This contrasts with the period from April 2020 to February where micro- and small-cap stocks dramatically outperformed large stocks.  If we do not see a re-rotation into smaller stocks and those outside the major indices may be the prelude to a larger market pause in the coming months.

Bonds too may have realized a bottom in mid-March as prices have been net sideways.  A bit more improvement in prices (rates lower) should begin a nice rally, giving a reprieve to the general investor who have gained in stock prices, but lost some on bonds, especially for the more conservative.

How could or would interest rates actually decline?  Again, we see in the media how ‘everyone’ knows rates are going higher and inflation is at the door due to either ‘cash on the sidelines’ (doesn’t exist), or bank savings, or ‘pent up demand’.  Once ‘everyone’ knows something its more likely the near-term trend is over or soon will be.  We may already see this in gold and bonds, as interest in these areas is low, while SPACSs and cryptocurrency are all the rage currently.

Inflation concerns are due to the recent and quick rise in rates that have its roots in price increases due to supply-chain problems and the Asian/China resurgence and stimulus.  Supply chains issues will be resolved on their own in short order.  High prices attract businesses to produce more/fix problems which lead to lower prices, the essence of a free market.   Very recent news tells us that China’s credit impulse/stimulus has begun to wane.  The past 10 years we have seen two previous large credit cycles in China.  China is a massive buyer of raw materials and we have seen prices in commodities rise the past year driven by easy money from China.  There is about a 3–6-month lag time until we see the impact of a change   in China’s rate of credit creation.   Given that this China credit data is already 4 months old should mean, as recent price action alludes, a decline in interest rates and commodity prices and thusly, inflation expectations.

While stocks look to have another 5-7% upside momentum, the asset classes that have faired worse recently should see gains alongside stocks.  As mentioned in the past Notes, its post July 4 that concerns me the most when we may see a flattening of economic growth and decline in expectations of rapid growth which can weigh on risk assets.

The reason I am concerned about the second half of the year comes from a few places.  Valuations are exceptionally high right now.  Many metrics are above 1999 levels.  This is commonly discounted due to the low interest rates.  If we are elevated over 1999 levels, how much more elevated should we accept? Another element to today’s market is the ever-present Fed liquidity.  Yes, the Fed could continue as long as there is dollar-denominated debt to liquify.   And finally, there is the current expectations that we are entering a new era of high growth.   Its this last item that is most sensitive to changes in short term economic and Covid data.

The high growth thesis stems from stimulus in the pipeline and the observations that inflation is occurring.   Stimulus, or government infrastructure spending will take years to filter through the economy.  Inflation as measured by the CPI varies greatly, while the PCE is smoother (and what the Fed watches).  One can clearly see the past overshoots of the CPI vs. the PCE, and PCE is trending down.  Once supply chain issues are resolved/lessened and Chinas credit impulse fade, its likely CPI will catch down to PCE.

If inflation expectations come down, while job growth and spending data come in cool, beginning in the next few months, we could see forward expectations and valuations come down, pulling ‘risk assets’ with it.  Add in any kind of Covid 4th wave or failure at herd immunity via vaccinations, we could see the most powerful driver of asset prices, optimism, take a hit; and along with it create a more volatile period for stocks.

Adam Waszkowski, CFA

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Client Note February 2021

March 2, 2021

February was a bit of a roller coaster, as the S&P 500 gained 6.5% into mid-month, then fell back 3.5% to end with a monthly gain of 2.7%, and year to date at 1.6%.   Gold continued its drawdown, losing almost 10% year to date.   Interest rates have been rising for over a year now.  The rise in rates, news of commodity gains (rising for year as well), and thus inflation concerns are in the headlines which likely means we are likely to see a reversal in these trends of some degree soon.

With our current and recent equity exposure overweight energy and technology we have been able to offset the negative impacts of bonds and precious metals, providing year to date gains for moderate and aggressive portfolios.  Conservative portfolios will likely get in the game as interest rates pull back.

Inflation, ‘reflation-trade’, and the rise in interest rates lately is very much in the news.  All have been rising since the market crash in Spring of 2020.  Recent readings remain below pre-covid levels.  In September 2019, the CPI index was rising at 1.75% annual rate and the 10-year Treasury bond yielded 1.7%.  Today we see 1.4% inflation and 1.41% on the 10year Treasury.  CPI has been at 1.2%-1.4% since August.    While the inflation rate has remained relatively flat, market interest rates after initially lagging inflation have caught up recently.  This recent surge in rates catching up, is what is in the news.  

What drives market rates are expectations of inflation.  Vaccine roll-out and a dramatic decline in deaths and hospitalizations is allowing for predictions of robust growth to gain traction.  The assumption is that mass vaccinations will allow people to return to work, earn and spend money, growing the economy to pre-covid levels (2007-2019 GDP averaged 2.3% annually).  I have doubts as to how quickly we will get back to pre-covid employment levels.    Here in Florida, we have had in-school teaching since August and bars and restaurants fully open back in September.  Since then, the Florida unemployment rate dropped from 7.3% to 6.1% in December.  The US unemployment rate went from 8.4% to 6.7%.   There may not be significant improvement in employment nationally for quite some time.  But in the very near term, a new round of stimulus will go out in March and impact short term spending and income statistics just as the first stimulus did, potentially giving us a false read on how strong incomes and spending are, and thus an ‘overshoot’ on inflation and interest rates.

Inflation is a slow moving, long term phenomenon.  Over the long term, stocks and gold hold their value against inflation.  For income investors the days of the bond mutual fund are over.  Buying short term bonds to hold to maturity then reinvesting the principle into another bond as rates rise is a short to medium term strategy.   The rise in rates has overshot inflation, and longer term were likely to remain range bound between 1.5% and .9% on the 10-year treasury. Right now, I am not seeing any scenario of rapid uncontrolled increase in inflation or interest rates.

Adam Waszkowski, CFA

 This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

Client Note December 2020

January 12, 2021

2020, despite a massive pandemic and a severe global recession, central banks, with some fiscal assistance from governments, have managed to keep financial asset prices elevated.  Significant declines in revenues, profits and employment arguably the worst since the 1930’s alongside surging stock index price levels, have conspired to give us the most overvalued market since 1929 or 2000 (some argue “ever”).    How long can this endure?  Depends on when central banks begin to whisper about ‘normalization’.

For 2020, the SP500 gained 18.4%, the aggregate bond index gained 7.5%, and gold gained 26%.  European shares eked out a positive year while the Asian indexes fared very well.  My conservative portfolios gained mid to upper single digits while the average moderate portfolio gained a bit more than 13% on the year.   The pullback in Moderna and precious metals provided a weak end and lackluster start to the year.    The energy sector was the worst sector in the SP500, losing 28% and the tech sector fared the best gaining 48%.  Healthcare and energy are likely to be strong outperformers in 2021.  The addition of TSLA to the SP500 has increased the risk of market volatility. Past observances of new additions to the index show they generally perform worse than prior to their addition.  TSLAs outrageous market value (valued more than the 9 largest global auto makers combined; selling at 28x sales) and the 7th largest company in the index, put the index and any sector it is in at risk of increased volatility.

Gold and gold miners are at risk of starting another correction.  Recent lows at Thanksgiving are being approached.  The rally from late November to January 6 was the largest run up since gold’s consolidation began in August.  However, IF we can hold the longer-term uptrend, upside potential is significant.   Bonds too, are seeing prices under pressure as metals/lumber/agriculture/oil prices’ surge is generating calls of “Inflation!”.   It’s quite early to claim prices are going up due to renewed growth.

Asia came out of the COVID-19 lockdowns much quicker and effectively than western nations.  This re-opening (as a result of very stringent testing/tracing/ and effective lockdowns) allowed those economies to re-stock and re-open driving up demand and prices for raw commodities.   From 2015 to late 2017 base metal prices and oil were moving up quickly.  Cries of inflation were heard then as well.  Inflation never showed up (unless you count 2.1% as INFLATION).  This is due directly to US consumer spending growth, or lack thereof.

Aggregate consumer spending is significantly below trend.    Dig a little deeper and you can see many economic indicators picked up in 2015 through 2017, then rolled over during summer 2018, after the brief impact of tax reform (most of the benefits went to the top where additional money isn’t spent). Current total annual spending was $14.8trillion and growing at 4.2% for the past few years (income at almost the exact same rate).  MOST recently spending has declined the past few months while aggregate income also is declining.  Today we can see the next few months will likely show a spending gap of $1trillion.  A $1trillion gap is almost 7% of total spending and reflects the concurrent GDP output gap and an outright decline in GDP of around 4% year over year.  Looking ahead, the real problem may lie in the US inability to deal with the virus effectively.  Yesterday, an article stated that in Ohio, 50% of nursing home workers are refusing the vaccine.   Layer in low compliance with mask mandates (>70% compliance in order to be effective), and I truly wonder if an end to the virus is, in fact, in the offing.

As a consumer driven economy, the point is, while one can find prices of products higher (or packaging smaller at the same price), we spent a lot less in 2020 and will continue into 2021.  And unless personal spending increases, we should not see a difference in the economy or inflation going forward.  This may bode well for bonds.  TLT the 20-yr treasury bond elf, gained more than 15% in 2020, but has fallen a similar amount off its highs this summer.  Expectations for higher rates may have gotten ahead of itself and we could be near a low in prices.  Layer in the fact that bets against prices are near extremes may indicate the decline in bond prices is nearing an end.

In addition, or perhaps running parallel to the decline in spending is the truly massive amount of people on unemployment insurance.  In 2006, Continuing Claims for unemployment insurance hit a low of 2.35 million.  This began to increase in early 2007 and hit a high of 6.62million in June 2009, after the Great Financial Crisis. By June 2010, this fell to below 4.5million, and continued to decline into October 2018 to 1.65million. Claims remained flat until February 2020.  May 9, 2020 claims hit 24.91million.  And over the past 8 months has receded to only 5.1million.  It was only in November that our current Continuing Claims for Unemployment Insurance fell below the GFR Peak in 2010.  The number and duration of unemployment today has not been seen in the post WWII era.  Fortunately, today, we have unemployment insurance and a Federal Reserve acting to support financial markets (almost perpetually since 2009).

We should not expect any kind of normalization in the economy or improving numbers at least until employment, and thusly spending, improve rapidly.  This is completely dependent upon containing the spread of covid-19.

Due to the length and depth of the declines in spending and employment, the longer-term collateral damage will not be seen until things begin to normalize. Once all the rent and loan deferments, PPP loans, random stimulus checks, and enhanced unemployment benefits disappear we will be able to see the extent of the long -term damage.   Ironically, that knowledge will come at the same time we declare victory over this virus-recession and may be concurrent with a market decline.

In the meantime, let us hope the Fed does not mention ANYthing about tapering the current $120billion per month they are pumping into the financial markets, hoping that the Wealth Effect is more than theory.  So, while prices continue to climb, we will participate and listen intently for any signs the Fed is “confident” enough to reduce the variety of market interventions currently underway.

 

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

April Recap: Narrative Changes

Stocks rose a fraction of a percent, gold fell 1%, and the bond index fell 1% in April, continuing the very choppy sideways price movement we’ve experienced this year.   The month ended just below middle of the price range we’ve seen since the market top on January 26th.

Over the past few weeks, earnings have been spectacular, growing over 20% on an annual basis.  Unfortunately, stock prices have not reacted well to this great news.  Earnings season appears to have a ‘sell the news’ feel to it.  This could support the notion that stocks were priced to perfection going into reporting season.    The decline in prices and increase in earnings has reduced the market P/E (Price to Earnings) multiple, which could allow stocks to rise back to January levels.   Tax Reform has accounted for about 1/2 of the earnings growth.  There are two issues going forward.  One is that continuing

to grow at that pace will be difficult since we cannot cut taxes every year (and the tax changes to individuals are front loaded—the reductions we have seen will fade in the coming years). Secondly, earnings’ growth slowing, even from 20% to maybe 12%, can be seen as a negative: “slowing earnings growth”.   Surprising positive economic data because of tax reform needs to show up immediately, otherwise, the ‘hope’ baked into stock prices may be removed in the coming months.

Through the month of April, the narrative of ‘global synchronized growth’ has changed as European economic data has come in softer than expected and the US economy has pressed on.  So now we see the US as a main driver of global growth.  In the very short term, this narrative change has given the US Dollar a boost up.   Over the past few months, ‘dollar short’ and ‘rates higher’ have been very popular trades and have begun to unravel.   A stronger dollar will do harm to future US corporate earnings, make $-denominated emerging market debt more difficult to pay back, and serve as a headwind to ex-US assets (emerging, Asian and European stocks and bonds).  And slower growth will not support higher rates for longer term bonds.

The change in the growth narrative/data has been substantial enough for the Federal Reserve to remove from its FOMC Statement, “The economic outlook has strengthened in recent months.”   Often the Fed will change a word or two in certain sentences.  They could have change it from ‘strengthened’ to ‘remains strong’ or ‘continues to expand’.  Instead they dropped it altogether.   This is influencing perceptions of how many times more this year the Fed will raise short term rates.  In the WSJ today the front-page headline, “Fed is On Course for Rate Increases”.  Given the boldness of this headline, its odd to see in the article an inference that even if inflation was stronger, the Fed wont raise rates more than already indicated, which is twice more this year.  There is a dichotomy in the Fed’s statement: taking out the growth story but keeping to the idea that rising inflation is OK, or even good.  Last time I checked, slowing growth and rising interest rates weren’t a good combination: stagflation.   The Fed needs to review the difference between ‘cost-push’, and ‘demand-pull’ inflation.

AAII sentiment for the week ending May 2 came out this morning and Bullishness declined, and Bearishness increased.  This is as expected given that stocks were down over those survey days.  Bullishness isn’t quite as low as I’d like to see for a good bottom, but if stocks can undercut February’s lows, we should see Sentiment get negative enough to support a rally in stock prices going into the late Spring.

Adam Waszkowski, CFA

“Good” Inflation: Rising rates and falling stocks

Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high).   Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date.  That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%.  Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year.  Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa.    When the classes move together differentiation across risk profiles diminishes.  Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth.   In this light, a rebound, or ‘buy the dip’ would not be surprising.  The new feature though is that volatility has returned.

The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness.  If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices.  At some point, earning safe interest attracts enough investors from stocks to weaken stock prices.  The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.

Rate have climbed due to rising inflation expectations.  Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’.  Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business.  This will take time but markets have already priced it all in.  Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations.  The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.

infl vs unemplmnt

Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’.  On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.