by Franklin J. Parker, CFA
The Summary
- Worries about inflation spread through risk markets last week despite assurances from the Federal Reserve that they plan to continue current policy for the foreseeable future. Bond investors were particularly unconvinced and the benchmark yield on the 10-year US Treasury spiked to 1.50% (meaning bond prices fell, generally).
- This week sees speeches from several Fed governors, as well as important data drops. We get a read on the health of manufacturing as well as non-manufacturing sectors from the Institute for Supply Management’s various indices.
- Manufacturing PMI posted this morning at a whopping 60.8—beating the expected 58.8! Anything over 50 is expansion, and 60 is about as good as that index ever gets.
- Headline unemployment data also posts on Friday and the expectation is a headline unemployment rate of 6.3%. Ironically, a post much less than that may be bad for risk assets (like stocks) as it could perceived as a trigger to slow easy-money policy.
- Last week’s market movements showed just how dependent all investments are on Federal Reserve policy. The traditional idea that bonds offset losses in stocks (and vice versa) has been broken as all asset classes have traded in tandem with the same cause: the Federal Reserve. In short, diversification is not working when we need it to. Finding alternative ways to mitigate risk in our portfolios, therefore, has become a chief concern.
The Details
I remember in 2008 how I began to question whether the traditional advice still worked. Diversification, specifically, was on my mind because it didn’t work very well. I remember in October of 2008, stocks, bonds, and gold were all down. Even worse, after the failure of Lehman Brothers, money market accounts were in danger of not returning dollar-for-dollar. The FDIC stepped in and temporarily guaranteed money market funds against loss just to calm the panic. In short, not even cash was safe in October of 2008.
Our current environment is not as dramatic as all that, but it poses similar challenges. Markets have shown us over the past year that diversification is not working like it should. In moments of stress, stocks, bonds, and even gold, tend to sell off in tandem! Yet, when markets rally again, they tend to not move up together. This gives us the worst of diversification with none of the benefits.
I am not advocating for the abandonment of diversification. However, I am beginning to use some other risk mitigation techniques within our portfolios. There are pockets of the bond market, for example, which do not trade so directly with the Federal Reserve, and cash is a nice hedge against stressful moments. Of course, I cannot be too specific because different individuals will require different techniques, but suffice it to say that we may be entering a period where tradecraft can play a greater role in portfolio management.
Chart of the Week
The big news last week was, of course, the move in 10-year US Treasury yields. They reached their highest rate in about a year. This week’s chart places recent yield changes in a broader context. Clearly, the past 12-months have been the aberration in yields, not the norm—a more “normal” yield for the 10-year US Treasury is in the 2% range (though even that is low by historical standards).
Recent moves can really be seen as a return to more normal times.
That said, there is a rather wonky technical effect also at play. Stocks are priced as the sum of discounted future earnings. Most analysts use the 10-year US Treasury as a discount rate. So, as this rate rises, stock prices should fall all else being equal. The second plot illustrates this. For the P/E ratio on the S&P 500 to remain the same when yields rise, economic growth expectations must rise, as well. Conversely, if rates rise and growth expectations do not, then the P/E ratio will fall (and so will price).
There are many forces at work, of course, so we cannot make too much of this. Even so, it is a legitimate effect that must be considered in our investment portfolios.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.