“Investing is not about predicting the future but preparing for it; seek not to
time the market, but to spend time in the market.”
– Chat GPT
LOOKING BACK
The stock market had a tough 3rd quarter with the S&P 500 declining about 3.3% This was mostly
becauseinterest rates were rising, and the Federal Reserve was also raising interest rates aggressively.
Both of these things make it more expensive for companies to do business, which can lead to lower
profits and lower stock prices.
Investors were worried the Federal Reserve's interest rate hikes would cause a recession. If that
happened, it would make for a difficult time in the stock market. However, it is also possible that the
Fed will be able to bring inflation under control without causing a recession. So, the 3rd quarter was
volatile, with stocks falling overall due to a number of factors, including rising bond yields and the
Federal Reserve's aggressive interest rate hikes.
What are bond yields?
Bond yields are the interest rates that investors earn on bonds. When bond yields rise, the prices of
existing bonds fall. This is because investors can buy new bonds with higher interest rates, making
older bonds less attractive.
How do bond yields affect the stock market?
Bond yields are important for the stock market because they are a benchmark for the cost of capital.
When bond yields rise, the cost of capital for governments, companies and consumers also rises. This
makes it more expensive for governments and companies to borrow money to invest in growth and
also increases the costs of things like mortgages for consumers. As a result, higher bond yields can
lead to lower stock prices in the near term.
For example, if one were to have taken out a mortgage in 2021 for $400,000 – at the then going rate
of 3.0%– your monthly payment on a 30-year term would have been $1,700 per month. So, $1,700 a
month for 360 months means you pay the bank $612,000 for your $400,000 house. Fast forward to
today at 8% mortgages and your monthly payment would be $2,900. Wow, that’s $1,200 a month more
for 360 months. That means you pay the bank a total of $1,044,000 for your $400,000 house. That’s an
extra $432,000 for the same home,just based on higher borrowing costs. It totally changes the game on
housing affordability. If you wanted to keep your payment at $1,700 per month you’d have to step down
to a $230,000 home. Incidentally, you’d be paying the bank a little over $600,000 for that $230,000 house
based on current rates. Now, extrapolate that across the entire economy for businesses and individuals
and you can see why interest rates matter so much. Ultimately higher rates can erode corporate earnings
resulting in potentially lower stock prices.
How did the Federal Reserve impact the stock market in the 3rd quarter of 2023?
The Federal Reserve raised interest rates by 0.75 percentage points in July and September 2023.
These interest rate hikes were the most aggressive since 1994. The Fed has been raising interest
rates in an effort to combat inflation. Higher Fed Funds rates can also slow down the economy and
lead to lower stock prices.
Overall impact on the stock market
Rising bond yields and the Fed's interest rate hikes were the two main factors that contributed to the
stock market's decline in the 3rd quarter of 2023. Ironically, corporate earnings from the second
quarter, which were announced in the third quarter were generally good. The lion’s share of third
quarter earnings will be announced over the next month or so and are anticipated to be fairly good
as well.
LOOKING FORWARD
Since we’ve been discussing the importance of interest rates and how they tend to affect stock
market performance, let’s continue with that theme. The debt or “bond” market is very important
since debt service, or the interest expense on your borrowed money, affects almost everyone –
governments, businesses and individuals alike.
Bond yields have been moving up strongly, pricing in the higher for longer stance by the Fed,
as well as the deteriorating demand-supply balance, among other things. Many suggest that
the July-Sept up move in oil prices should mean further rally in bond yields, as inflation could
increase again.
We do not subscribe to this view and believe that we are currently in a transition phase, rising
bond yields at these levels are problematic for investor sentiment and for the economy, and
are therefore ultimately not sustainable. Bond RSI’s are becoming oversold, and could start
pricing in a policy mistake, where bond yields are likely to start to move lower. Bond RSI’s
are just a technical indicator that tries to determine if bonds are overbought or oversold. We
also look to RSI’s for short-term movements in stocks as well.
The oil price rally does mechanically imply that PPIs (producer inflation), as well as CPIs
(consumer inflation), could inflect higher again, and we note that historically oil and bond yields
were most of the time positively correlated. Having said that, unlike the 2021-2022 episode,
where bond yields and oil were moving up together in order to reflect the economies reopening,
and where the consumer at the time was accepting of rising prices, given pent-up demand and
a strong post Covid liquidity position, the recent oil rally was mostly for supply reasons. This
could lead to demand destruction, and be deflationary, rather than inflationary.
Further, looking at the past eight Fed tightening cycles, post the final hike, bond yields were
down each time, by 100bp or 1%, on average, irrespective of whether the recession or the
soft landing followed. We acknowledge that US fiscal deficit is significant, with deteriorating
supply-demand picture for government bonds, but yields are at present trading much above
the inflation forecasts, and above the levels of economic activity, with growth at risk of softening
post the strong Q3 earnings announcements.
If bond yields roll over, will it help equity valuations making stocks seem cheaper? Not if yields
are peaking at the time when earnings, and the broader economy, start to disappoint, which
could be the case as we get late into the first quarter next year.
There has been a significant repricing in the bond markets since the spring, with US 10-year
up 150bp or 1.50%. This was initially driven by the more favorable growth outlook, but more
recently by the less supportive demand-supply balance for fixed income, as well as the
adjustment to the higher for longer Fed. Indeed, US 10-year yields are now the highest since
2007, and other markets are also making multi-year highs.
Since August, equities are not responding well to this, and the risk is that the tightening in
financial conditions spills over into the real economy. Markets could start to discount the
possibility of a policy mistake, where central banks overstay their welcome. US mortgage
rates are now at two-decade highs.
We think the recent move up in bond yields is a bit of a capitulation trade, and during Q4
the levels would be very attractive to lock in higher yields. The move up in bond yields
might not be sustainable, and many fixed income analysts are looking for yields to fall from
current levels in most places.
FINAL THOUGHTS
Trying to forecast what the markets will do next year is a bit of a bridge too far as there
are so many variables that could change any time between now and then. Anyone who
makes forecasts beyond about six months probably has some oceanfront property in
Arizona to sell you. Having said that, if earnings continue to come in as good as they
have thus far, the next quarter looks promising. We are also in the 3rd year of the
presidential election cycle of which the beginning of the year tends to be the strongest
and then historically whimpers around in the middle-to-late part of the year before finishing
strong. As you can see from Ned Davis Research’s chart below, it’s not a crystal ball
indicator, but the trend does seem to fit. Also keep in mind this data is an average going
back to 1900 and takes into account all political parties.
As for the markets – the remainder of the year, if earnings hold up, which they appear to be,
we could get close to the all-time highs again in the S&P 500. Continued by the rally in tech,
this market has been the most doubted with the most negative sentiment I have seen in some time.
I have read that short interest in this market is very high. Usually, the herd is wrong. Early in the
year many respected Wall Street analysts predicted year end numbers far below where we reside
today. Obviously, there are many moving parts that drive stock prices, but one of the most important
besides corporate earnings is employment. When people have jobs and money, they spend it. With
the current high interest rates the economy may be getting a little long in the tooth. And, yes, next
year is an election year and the chart above portends some additional volatility during election years.
However, that trend is still upward sloping going back 122 years. For the heck of it I asked ChatGPT,
a machine, for investing wisdom and it gave me the quote at the top of this update. If the machines
have figured it out, why can’t we? After all, we’ve given them all of their knowledge. Something to
think about.
If you have any questions or would like to discuss anything in this update or any other matter, please
feel free to give me a call. As always, I’m honored and humbled you have given me the opportunity
to serve you.
Sincerely,
