The first half of this year has been unusually strong for stocks with the ACWI Index of global stocks returning 16% through June 30. A nearly 35% annualized return (compounded) is much better than we should anticipate for stocks in the long run. Additionally, bond yields declined this year, and the 6.1% return for the Bloomberg Barclays Aggregate US Bond Index in just six months was much higher than we should expect for bonds in the long run as well.
Given current stock valuations, it is not unrealistic to expect long-term average annual stock market returns in the 5-7% range. The first quarter’s return for stocks represented nearly two years’ worth of such returns, and now at the year’s mid-point, we have been given the equivalent of nearly three years of stock returns in six months. This feels good in the moment, but when stock prices advance absent similar improvements in fundamentals such as earnings, nothing extra is created in the long run as investors are just paying more for the same earnings.
We also note that certain indications of market “froth” have appeared this year, perhaps most notably in the booming market for initial public offerings (IPOs). This year to date, 81% of the stocks that have come public have had no earnings. That is double the long-term average of 40% and higher than other periods except for the frothy dot-com bubble era of the late 1990s. This is just an observation, not a justification for any anticipated action, but it may be a reason for some caution.
Most questions we have received recently have been about tariffs, the Federal Reserve, or the “yield curve”. We’ll seek to address each here.
Tariffs and saber rattling with respect to trade disputes with China gather great attention these days. The key point to remember about tariffs now is that they are part of a negotiation of trade disputes. As such, they may not be a permanent condition. We have no idea how, when, or if these disputes will be resolved, but if they ultimately do get worked out, markets may have created opportunities in those companies most affected by trade, particularly with China.
Last year, the Federal Reserve Bank raised short-term interest rates. In the first quarter of this year, the Fed left rates unchanged and said it would likely not increase interest rates this year. In the second quarter, the Fed also left rates unchanged but signaled it may actually cut rates soon. Our sense is that the market’s celebration of this change in outlook for the Fed looks overdone. Markets have soared in anticipation of an easier Fed, so much of the perceived good news for markets may already be “baked in”.
Last quarter, we wrote about the inverted “yield curve” - the relatively unusual condition in which short-term interest rates are higher than longer term rates. That gets lots of attention since it often precedes a recession. It doesn’t guarantee an economic slowdown, but most would concede that it raises the odds. Our take is that this bond market is one that is not priced to reward either type of bond risk: interest rate risk or credit risk. Interest rate risk is the risk of bond prices falling due to rising interest rates, and it impacts long-term bonds much more than shorter term bonds. With a flat or inverted yield curve, we are not earning a higher return for holding longer term bonds, as we should demand. Similarly, with the yield curve signaling greater risk of recession, we see little reason to embrace more credit risk, or the risk of default, in bond portfolios either. So, given the current state of the bond market, we are seeking to embrace both less interest rate risk and less credit risk in bond portfolios at the same time, electing to temporarily give up modest incremental yield to do so.
Inversions of the yield curve don’t just tend to precede economic slowdowns, they also have some tendency to coincide with changes in market trends. These are never identifiable with certainty except in hindsight. But we will note two market trends that appear to be “long in the tooth”: 1) the multi-year run of international stocks underperforming domestic stocks, and 2) the multi-year run of value stocks underperforming the overall stock market. Time will tell if this proves to be a turning point for either trend, but in the event it does, that would likely help the relative performance of our managed portfolios, given their current holdings. So, while most clients view the inversion of the yield curve as something to fear, it may bring somewhat offsetting but less heralded benefits. Time will tell. In the meantime, we appreciate the opportunity to be of service and invite any questions.