During May the S&P 500 declined 6.35% on a total return basis, or after adding back in all dividends, and the 10-year U.S. Treasury note yield fell from approximately 2.5% to less than 2.1%, after yielding over 3.25% during November. This collapse in bond yields has occurred due to the beliefs that corporate profits have peaked, the US and global economies are slowing, as well as a flight-to-quality response to geopolitical tensions. Trade tariffs with China and Mexico are at the forefront of this narrative. The rush for the hills and into high-quality bonds has pushed the S&P Muni and Barclay’s Aggregate indices up 4.49% and 4.79%, respectively, year- to-date through May 31st. The broad U.S stock market (S&P 500) ended May up 10.74% year- to date, down from its YTD high of over 18%.
What is a rational investor to do now? Will the equity market’s decline in May continue? Are we headed for imminent recession, as some believe, and lower stock market prices? And what about the direction of interest rates?
To buy something exceptionally cheap or of great value requires paradoxically owning something that nobody else wants, then patiently waiting for prices to rise. In a raging, momentum-driven bull market like we saw during Q1 this strategy could be termed “contrarian.” Contrarian value investing produces the best results over the long-run but requires going against the grain or short-term flow of the market. Additionally, the financial markets do not like uncertainty in the near-term. The greatest uncertainty we now face is trade tariffs.
Although the current business cycle has been especially long-winded, we believe that both the stock and bond markets have likely overshot due to the recent barrage of negative news headlines on all of the aforementioned fronts. We believe that our global trading partners have more to lose than gain from a trade war with the US. Therefore, we think the probabilities lean towards some kind of forthcoming trade agreements amenable to all parties.
The negativity of May is likely behind us with the markets having already discounted these headlines. Farmers, business leaders, and consumers may have altered policy and spending habits temporarily in response, however, lower bond yields are markedly helping US business and housing finance through significantly lower lending terms and mortgage rates. Stock valuations have declined significantly. The Federal Reserve appears to be on pause. With the 10-year Treasury yield in the low 2s, or nearly fifty times earnings, stocks, especially US stocks, are relatively attractive.
Historically, most bull markets do not end until two of three things occur: a) a tightening Fed; b) recession; c) a shock in energy prices. While you could argue that the Fed is tightening through “quantitative tightening” or the unwinding of the Fed’s balance sheet, this is scheduled to end this fall. The futures markets are indicating the Fed’s next move to be accommodative – an easing consistent with recent Fed minutes and Fed Chairman Powell’s comments.
Since WWII we have had 14 tightening cycles including this one, and in ten of the prior thirteen the Fed went too far and pushed the economy into recession. While the evidence reveals the Fed’s very poor batting average, the jury is still out on this one. Again, the Fed is no longer raising the Fed Funds rate; GDP growth has been strong; recent tax reform has a multi-year tail wind. Given the recent discounting of forthcoming slower global economic growth and rise of US energy independence, crude oil and natural gas prices have fallen well into double-digit percentage price declines, making gasoline prices at the pump more consumer friendly.
With the likelihood of good news just around the corner, we would recommend that stock and bond investors rebalance their allocations. Specifically, investors should trim bond holdings and add to beaten-up equities. Given the sharp decline in bond yields, we also recommend shortening duration of bond portfolios for two reasons: First, short-term bonds (one year or less) yield as much or more than 10-year bonds, and without the interest-rate risk; second, bond yields are likely close to long-term or “secular” lows and too low to make long-dated holdings worth it, making shorter term assets much more risk averse, and without any give up in returns.
Please call us at 318-675-0826 if you have any questions.
Sincerely,
Jack E. Ditt, Jr. William L. McCollum
