Quiet Holiday Trading
This isn’t your father’s bond market anymore. While it may be a bit early to stick a fork in the multi-decade rally in bond prices (and drop in yields), it is increasingly evident that the all-time lows hit over the past year or two are likely to be “the” lows. The Fed played the Grinch for the second consecutive year, raising rates at their last meeting ahead of the Christmas holiday. Citing a growing belief the economy has turned the corner, the Fed is now expected to raise interest rates three times in 2017. Of course, they were going to hike four times in ’16 and managed just one. Ms. Yellen also poured cold water on the additional fiscal spending plan, saying that a “cloud of uncertainty” surrounded his plan, but they would continue to be data dependent well into the New Year. The holiday rush also includes the economic data with 24 pieces of data last week and 18 ahead of the Christmas break. As has been the case all year, the economic data is showing some strength, but not enough to say the economy is booming, just merely muddling along. The markets should be relatively busy into Thursday’s data dump, but there will be little trading the remainder of the year as investors shut down for the holiday.
Investors continue to believe the world will be a better place with a new administration and handling of regulations. After three days of not setting all-time highs, investors are beginning to look around and wonder if all the bullishness might be excessive. The combination of high valuations, higher interest rates and very bullish sentiment has resulted in a few indicators flashing yellow. The last instance of these indicators lining up was in early 2014. Although stocks still rose, the early 2016 decline put stocks unchanged for that two year period. In short, the sledding might not be as smooth early in 2017 as investors reassess the policies and timing of their impact on the economy. Additional warning flags include fewer stocks above their long-term averages, especially compared to the numbers reached early and mid-year. The good news is that stocks continue to make new highs and volume has favored the bullish camp. A rest for stocks is due. But at this point, a “normal” 5-7% pullback is expected as investors reassess the economy and market expectations.
The Fed finally did what everyone expected and increase rates. Their assessment of three hikes for next year was a surprise and kept bond investors very defensive as yields continue to rise (and prices fall). One interesting part of the bond market has been the municipal market. Municipal bonds are exempt from federal income tax and have been a nice place for higher tax-bracket investors to get income. Expectations for lower tax brackets have soured investors on this part of the market and rates, while other parts of the market are increasing. What makes little sense is yields for many municipal bonds exceed treasury bonds, where the income is taxed. The sell everything and ask questions later is creating an opportunity within various parts of the bond market for not only good income returns, but also capital appreciation.
Surprise, surprise, surprise, income investing is back! After turning their back on utilities, REITs and consumer stocks, investors last week flocked back into these investments. In what may only be a temporary respite from persistent selling since mid-year, these groups were among the big winners last week as the broad market went sideways. Profits were taken from the “Trump Trade” sectors like financials and industrial stocks. Even as the Fed increased rates, investors moved back into the more interest rate sensitive sectors last week. One constant last week was the dollar, as it continued its dramatic rise since the election. Up until the election, international investing was actually enjoying a bit of a renaissance, after performing poorly for much of the past five years. That ended with the election, as emerging markets have fallen over 5% and developed international is flat vs. a US market up 5%. Investors maybe fearing a protectionist tilt in the US (and around the world), which is forcing money back into domestic holdings. In the US that means smaller stocks, which are up over 10% since the election. These dramatic moves in the markets are not likely to persist as valuations eventually win out. The US is very expensive and international, especially emerging markets is very cheap.
Whether the rotation back to what was working earlier in the year (dividend stocks) is temporary or born from a realization that a new administration will not be making extreme changes all at once, will take time to play out. Even with higher interest rates, the absolute level of rates remains very low by historical standards. Keys to future increases will come through in the employment reports, wage growth and a pickup in retail sales. So far, these point to still muted economic activities. Like the Fed, we remain data dependent as well and not getting carried away with the emotions of today.
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.