This week, the market broke out of its holding pattern from last week. Unfortunately, the breakout was to the downside. However, the selling during the week is consistent with a consolidation period which historically sets the table for the next leg up. There may be more consolidating (read, selling) before that table is set, however. If you watch financial news you hear all kinds of scary explanations for this from spiking interest rates, out-of-control inflation, too much stimulus, bubbles, etc. I will address each but first, some context.

Last year, we reached a short-term peak in the Dow, S&P 500, and NASDAQ on September 2^nd after months of incredible gains (which followed historic pandemic-induced losses). In the three weeks following September 2^nd, the Dow lost (6.7%), the S&P 500 lost (9.6%), and the NASDAQ lost (12%). That was table setting for the next leg up. Since those lows roughly 5 ½ months ago, at the recent market highs, the Dow had gained 16.5%, the S&P 500 gained 22%, and the NASDAQ gained 33%.

I am not predicting similar gains over the next 5 ½ months but I am suggesting that, just as with the downturn in September, nothing fundamentally in the economy has changed, other than perhaps yields on Treasurys. There has been a lot of talk recently about how the rapidly rising yield on the 10-year Treasury is creating a competing investment to the stock market. At the moment, this sounds like talking heads trying to find something to talk about.

The 10-year Treasury has risen rapidly, spiking to over 1.6% yesterday. This is now slightly above the dividend yield on the S&P 500. Hence the recent chatter about competing investments. Consider, the 10-year Treasury averaged around .70% last September when we suffered the losses mentioned above. Clearly, Treasury yields were not the problem then. Nor last spring when the pandemic sent yields down to 234-year lows (lowest in history).

As I type, the ten-year Treasury yield has dropped back below 1.50% and represents one of the lowest yields in history. It seems ridiculous to me to suggest that because the 10-year Treasury pays roughly the same as the S&P 500 dividend yield that investors will take money out of the stock market to buy this “competing” investment.

In fact, the yield has risen because of a good deal of selling that has occurred in the Treasury market, driving prices down and thus yields up. Why the selling? Because traders anticipate robust economic growth around the corner and fear of a bit of resulting inflation thus making the current yields on treasuries net of inflation at or below 0%. That does not sound like much of a competing investment. As well, we do not see bear markets occurring during strong economic growth.

Regarding higher yields creating a rotation from stocks and into treasuries, history reveals the foolishness of that conclusion. During the 1990’s, the 10-year Treasury yield ranged between 4.7% and nearly 9% while the S&P dividend yield ranged between 1.22% and 3.14%. Throughout the decade, there was huge gap in yields favoring the 10-year Treasury. Yet, the 1990’s were one of the best decades in history for the S&P 500, averaging over 17.50% per year including reinvested dividends. During the most recent decade, the 10-year Treasury ranged between roughly 1.50% to 3.50%, while the S&P 500 dividend yield ranged between roughly 1.50% – 2.75%. It, too, was a great decade for stocks with the S&P 500 averaging roughly 13.50% per year with reinvested dividends.

As we seem to be getting to the end of the pandemic sooner than most thought even a month ago (a period during which time we have seen yields spike), it seems to me that Treasury yields are normalizing back to pre-pandemic levels.

Inflation concerns have also led to recent selling in the stock market. One talking head yesterday was actually given ample airtime to talk about fears of returning to 1970’s levels of inflation. He ended his segment suggesting, “We’re not there yet…” Um, no, we are not there yet. In fact, we are as close to 1970’s inflation as we are to 1970’s fashion styles. A serious conversation can be had discussing concerns about inflation rising a bit above the Fed’s 2% target rate and whether that will force the Fed’s hand to raise rates sooner than currently believed and what the implications of that may be, but it is not a serious discussion at this point to be talking about 1970’s levels of inflation.

The Fed is not concerned about inflation. The Fed is more concerned about continued troubling signs in the economy and in particular labor. The Fed believes that if inflation does rise above its 2% target rate in the coming months, it will be short-lived and the risks of doing too little on stimulus are greater than doing too much. In recent comments over the past couple of weeks, the Fed has reinforced its commitment to keep the Fed funds rate at its current historical low for a long period. If so, it appears unlikely to see the 10-year Treasury yield rise much higher.

Activity in the inflation-protected Treasury’s (TIPS) would confirm the belief of a potential short-lived increase in inflation. The difference between five-year Treasury and TIPS yields shows break-even inflation expectations have risen to nearly 2.4% in recent days—the highest level since May 2011, implying inflation is set to pick up. Shorter-term break-even rates are higher than longer-term ones, an extremely rare situation—known as an inversion of the break-even curve. This forecasts a spike in inflation that then falls away.

The pending $1.9 trillion stimulus, however, is turning into more of concern for the markets than a boon. With the pandemic rapidly coming to an end (hopefully) and the economy appearing set for robust growth with new economist’s consensus estimates for 2021 GDP growth already north of 6%, more economists, including those who held cabinet positions under the Obama administration, have suggested that no stimulus is needed, and the size of this bill will cause more harm than good due to its potential to usher in rising inflation.

As well, its passage is stoking concerns about governance in Washington and its impact on future economic growth. The last two stimulus bills under the previous administration passed along bi-partisan lines in the House and Senate. From what we read, it appears the newest stimulus bill has a majority of the funds targeting interests and areas that are not related to the pandemic and would not pass the House and Senate. It will therefore pass via budget reconciliation, a process that bypasses the needed votes in the House and Senate.

I am not one that believes the stimulus will do more harm than good, at least not for the foreseeable future. And as an asset manager my job is to invest today for the coming months and quarters, not what may happen in nine months or a year or longer. We will address any potential concerns in the coming quarters. I believe this stimulus should pass as is and will provide a needed shot in the arm for the economy to get through the final stages of pandemic-induced struggles and will accrue favorably to corporate earnings and the stock market. Our current Treasury Secretary and Fed Chairman agree.

Meanwhile, home prices have been one bright spot in the economy with the Case-Shiller home price index year-over-year, growing 10.4%. Consumer Confidence Index also improved recently to 91.3. Wednesday numbers for New Home Sales also showed a huge increase, blowing away expectations. Today, Personal Income showed a 10% increase from January while Consumer Spending increased 2.4%. However, jobless claims and continuing claims, areas of great interest to the Fed, continue to be stubbornly high, still higher than the highest levels during the financial crisis.

On a final note, good news on the pandemic appears to be accelerating and sustainable. Numbers of infections, hospitalizations, and deaths have plummeted over 75% from recent numbers during the second wave. And, with hundreds-of-millions of vaccines soon becoming available to all, it is likely these numbers will improve rapidly and not reverse again. In addition to the obvious health benefits, that will soon show solid benefits in economic growth. There is much to monitor in the coming months and quarters, and we will continue to keep you updated and update our investment allocations as conditions warrant.


Have a Great Weekend

Scott Barcomb