Insights & Thoughts

Tennis Anyone?

Mar 19, 2019 | Quarterly Commentary

One of the more comical images is the crowd at a tennis match; hundreds of people swinging their heads in perfect unison for hours. Synchronized swimming has never been this coordinated. This image comes to mind when I watch the daily financial news on TV. The pundits the networks bring out perfectly reflect the direction the market is moving at the time. It’s either the sky is falling or the sky’s the limit. There’s no doubt it’s got to be hard to fill hours of programing on one subject day after day, but it can be really confusing if you’re wanting to actually understand where things are headed.

This phenomenon has been especially pronounced lately. The final months of 2018 were pretty brutal for stocks, globally. This was especially true in December. The first quarter of this year has been just the opposite, however. Thru mid-April, the S&P 500 is up nearly 16% for the year. Small cap stocks are up over 14.5% and the mid cap sector is leading at roughly 18%. These gains have all but erased the selloff 2018. Interestingly this year’s gains are just about on par with last year’s gains prior to the fourth quarter selloff. So what is all this telling us?

Such a dramatic swing would imply that there has been a major change in the fundamentals of the economic outlook. To see these swings in both directions as has occurred over the last six months seems to imply the market is saying “the economy has really taken a turn for the worst. Oh, never mind.”

Here’s our take on all this. It all boils down math. More specifically, the market valuations are driven by the present value calculation of corporate earnings. A big variable in this are interest rates. Look no further than the changes in yield on the 10-year treasury bond over the last six months. The 10-year treasury is widely recognized as proxy for overall interest rates in the economy.

The yield on this bond rose steadily and quite dramatically from September of 2017 thru August of 2018. The stock market was comfortable ignoring this rise early on because the yield was still quite low. This sentiment change, however, once it crossed 3% and kept rising. This corresponded with the peak in the stock market last year. For most of the fourth quarter the yield fluctuated between 3 and 3.25 percent. This is precisely the time period when the stock market turned negative.

Once the selloff became serious enough to catch everyone’s attention, two things happened. First, money flowed out of stocks and into bonds, as investors sought safety. Second, the Federal Reserve did a complete about-face on their 2019 monetary policy, stating they’ll hold on any future rate increases. This position essentially marked the bottom of the stock market. Since then the 10-year yield has steadily declined, dropping below 2.4% and stocks have retraced virtually all their losses. yield and stock prices have been a mirror image of each other.

There are a great many drivers of the economy. These are the topics you’ll hear constantly discussed in the news. At any given time, some will be positive and others negative. This is why it’s so easy for the news to paint a picture one way or another. It’s just a matter of what they choose to focus on. It’s challenging, at best, to stay on top of all of these data points and even more so to weigh the relative importance of all of them. Interest rates are a good way to judge all of these variables because all of this information is essentially packed into the yield curve. Market participants around the world vote with their dollars every moment of every day as to what they think about GDP and inflation. This is why the yield on the most liquid bond in the most liquid market tells us so much.

Going forward, we think most of the stock market gains for the year have been had. If we’re focusing on interest rates, the Fed is going to play a major role in what happens throughout the year. The Fed is generally a non-political entity (which is vitally important), but we are headed into a presidential election cycle. This means the pressure will be on for them to be cautious about raising rates.


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