Finance

Earnings In Full Swing

PaulNolte-2

In a mere few weeks we will witness a rather historic event. Yeah, we all know about the first woman or the first non-politician president. But one baseball team will continue their historic futility, while another will finally break theirs. In Chicago, it has all been about the plan hatched five years ago to get to this moment. Unfortunately, the same can’t quite be said about the economy. The plan hatched by central banks to push rates to zero or below was meant to spur spending and pull the economy out of the recession. Those negative rates, instead, forced additional savings, investing in markets and paying down of personal debt. None of those activities added to economic activity. So the grand plan of central banks, steeped in economic theory and backed up by complicated mathematics was thwarted by the lowly everyday consumer. Central banks are now reconsidering their zero interest rate policy and working toward trying to bump rates up a bit over the coming year, as long as financial markets don’t completely lose it over the loss of “free” money. “Sometimes you win, sometimes you lose, sometimes it rains”. And so it goes for the financial markets.

The scary October period for stocks is but a week from being complete. Many of our short term market indicators have rolled over and indicate a few more weeks of rough markets. Not that the last few weeks have been all that rough, but the markets are unchanged from early July and too, unchanged from May of last year. The markets put in an important bottom early in February, when everything began to rise from the fears of lower oil prices and the fallout from the first rate increase. Emerging markets, small cap, energy and even high yield all bottomed out in mid-February. But over the last month or so, many of these asset classes as well as stocks that make up the asset classes are looking tired. Whether concerns over the election, typical October selling or worries about earnings season, it looks as though the markets are poised for a break. We don’t believe anything more than a 3-5% decline is in the offing and would be considered “normal” and should not alter overall investment strategies. There are some changes between the various asset classes that we’ll outline below, but we do not yet see the evidence of a longer or larger market decline in the near future, just more of the same frustrating and grinding market.

Interest rates have likely bottomed, finally! Our bond model has been calling for higher rates over the last two months and the markets are obliging. Very short-term rates have “jumped” from a mere basis point to over 0.35% during the past year. Two year bonds have been gradually rising over the past three years, from 0.20% at the lows to just over 0.85%. These new, “higher” rates are not enough to throw up white flags and run for the hills, but it is an early sign that returns from bonds will be much tougher to squeeze out in the months and years ahead. As interest rates rise, the value of bonds declines, potentially erasing the earnings from the interest payment. For investors very used to very good returns from the safe bond market, those days may be drawing to a close.

As referenced above, many asset classes bottomed out in February. However more informative are those that have recently peaked and have begun to decline. We highlighted bonds above as one major asset class that is struggling. Others are related to bonds: REITs, consumer staples and utilities. These three sectors have been steadily outpacing the broad stock market since mid-’15 and all three peaked near the end of July. Our bond model turned negative at that time as well. These sectors historically have paid very good dividends and provided nice appreciation, especially since the market bottom in ’09. They have been used recently as substitutes for bonds with the added benefit of better income and growth. That changed as investors began to realize the Fed and central banks around the world are beginning to reconsider their zero interest rate policy and actually start looking at increasing rates. A rotation from these groups to financials (a beneficiary of higher rates) and technology (good revenue generation) began at that point and continue through today. It will be important for central banks and the Fed to follow through with their promises to keep that shift alive.

We are short-term encouraged, but long-term cautious toward stocks. Over the short-term, emerging markets, technology and financial stocks are leading the way higher. Long-term, valuations should keep a lid on outsized gains; meaning whatever we get today could be erased later. Bond investors should be looking to buy more intermediate term bonds as a hedge against rising rates. This means the bond portfolio “turns over” quicker and are more able to lock in rising rates.

The opinions expressed in the Investment Newsletter are those of the author and is 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.