Stocks

Forget interest-rate hikes and quantitative tightening. There exists a very important weapon in the fight against inflation that the Fed did not have at its disposal in the 1970s: an overvalued stock market.

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The Fed has communicated it’s inflation target in uncharacteristically-plain English. Maybe they need to dumb it down more, because it’s the investors in English-speaking countries who have been the most surprised by the recent pickup in the inflation numbers!

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In the past we’ve made the observation that adding/deleting stocks to/from a popular index can have a profound impact on the target stocks’ short-term trading volume and performance.

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A preview of the upcoming Of Special Interest that will examine if the tortured process of Brexit is creating an opportunity to bottom fish washed-out and unloved U.K. stocks. Time to buy?

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A review of Quality factors, as well as the lower valuations of High Quality stocks, supports the current High Quality cycle amid rising market volatility. The Leverage factor may provide particularly strong backing for High Quality stocks.

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In mid December an Interim Memo was sent advising clients of a negative change in our Early Warning Index, an indication that an intermediate top was forming. It has been about four weeks since that alert and the work has continued negative.

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While the Dow Jones Bond Indicator has stood the test of time, history shows that rising bond yields are not always a bearish stock market phenomenon.

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In the context of a low growth/low inflation environment, with the Fed taking its time to guide rates upward, fixed income type of investments may pale by comparison to dividend paying stocks.

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We were surprised to see that all differentials ten years and longer are still below their respective 1926-to-date medians, indicating they still have the potential to keep moving towards historical median levels. We expect stocks to outperform bonds going forward.

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An examination of this historical relationship turns up some interesting findings that challenge the traditional disposition.

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Periods of accelerating inflation generally lead to lagging stock market performance.

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Stocks win the bonds versus stocks comparison.

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Stock/bond Risk-reward relationship beginning to return to normal. Back in Q1 2009, performance differential between S&P 500 and 10 year T-bonds was at generational lows. In prior periods of bond superiority, stocks ultimately came soaring back. Expect to see stocks do much better over next 5 years.

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At times it is indeed possible to have interest rates rise and stocks also move higher, and it is also possible to have rates decline and stocks fall.

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 Expect stock prices and interest rates to move higher together for a while. There are plenty of examples of this historically...although some of them go waaayyyy back.

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A look at stock performance in various inflation environments would seem to predict below average performance in 2009, but threat of monetary debasement inflation in 2011 and beyond could set the stage for poor performance.

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As of the end of Q1, the 20 year total return ACR differential between the S&P 500 and Ten Year Treasuries was negative, and at its lowest reading in 60 years.

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Despite strong stock market returns relative to 10-year Treasuries, the “generational anomalies” still exist. Stocks should outperform bonds going forward.

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So, over the long run, stocks are supposed to provide better returns than bonds as compensation for taking greater risk. Well the last 20, 30, and 40 year periods show that bond and stock returns have been at the smallest performance spreads ever. In some cases, bonds actually produced better returns. It’s pretty depressing huh?

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