Go Big Or Go Home

PaulNolte-2“Things are going great, and they’re only getting better…future’s so bright I gotta wear shades”. Rate cuts from China and more promises of easy money from the Eurozone put a bounce in investor’s steps, pushing stocks back to levels last seen in late August, just before the 10% decline. The euphoria is due to the (still) easy monetary policies around the world. Our Fed, while still chatting up a rate increase, is not likely to make a move until 2016 at the earliest. If short-term money is going to be worthless, then stocks are the default investment to get any returns. It also didn’t hurt that earnings from headline companies like Amazon, Microsoft and Alphabet (formerly Google) surpassed expectations. Interestingly, from strictly an economic perspective, little has changed in the US. GDP, income and spending as well as durable goods orders will be among the highlights of the week. Yes, the Fed does formally meet this week, but is not likely to provide any new/better insight as to their intent to hike rates. Far from being a scary month, this October is shaping up to be the best since 2011, the last time the markets had a 10% correction.

The past four weeks, stocks have jumped nearly 7%. But that four week period can be cut into half, with the formerly downtrodden energy, industrials and basic materials leading the way. The last two weeks has been technology and finance. It should come as little surprise that the markets, on a short-term basis, could use a breather. The good news is that investors have not yet embraced this rally and gotten very bullish. The technical condition of the market looks better than it has all year. As mentioned above, the market seems to be tracking the 2011 performance. In fact, the correlation between the two years is over 70%. So, if this year finishes up in a similar fashion to 2011, then stocks can rise another few percent from here, including a 9% decline that would show up in a few weeks. No two years are exactly alike, and this one is relatively expensive compared to 2011. Earnings are up only 8% over the past four years, while stocks have jumped 60%, pushing valuations toward 10 year highs. While cash and bonds help smooth returns when stocks go through their usual temper tantrums, the near zero returns keep pushing investors inevitably back into stocks in an attempt to generate a return. With the Fed comfortably on the sidelines and global central banks providing additional liquidity, investors are rushing back into stocks.

Short-term bond investors got a raise this week, as the treasury auctioned off treasuries at the incredible rate of 0.015%, up from exactly zero in the prior two weeks. $26 billion got turned over with nearly $100 billion in “demand”, indicating that even at these rates, there continues to be strong demand for US debt. Fears of investors losing interest in bonds, forcing rates higher, seem to be overblown at this point. The model used to project short-term trends in interest rates has been consistently calling for lower rates since early 2011, when the 30 year bonds were yielding over 4.5%. Today those bonds yield less than 3%. How low can long-term rates go? If we are indeed “turning Japanese,” their interest rates have been below 2% for much of the past 15 years and today are just above 1.10%. If and until the US is able to demonstrate consistent inflation and wage growth, long term rates can and likely will continue their descent.

The larger the stock, in terms of market capitalization, the better the returns have been this month. The largest 100 stocks are up nearly 8.5% in the past month, mid-sized companies less than 4%, and small cap just over 2.6%. The narrowing of the rally higher to just a few stocks has characterized this market since the end of the first quarter. Outside of a few months of good small stock returns, large US has dominated performance since the start of 2014. Within the SP500, the reign is officially over for healthcare. It dominated the returns of the SP500 since 2011 and has woefully under-performed the SP500 since the end of August. Taking its place at the top are the “safe” sectors of consumer staples and utilities. This change is due in large part to the better performance of these two sectors during the market decline of the past three months. We would expect to see continued rotation toward technology in the weeks ahead.

The straight up nature of the market over the past four weeks should take a breather this week; however the push to still lower interest rates may force more money into stocks the rest of the year. While the comparisons to 2011 are interesting, we don’t think they will hold through the end of the year. Barring a jolt from international markets, we should see modest market returns the rest of the year.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.