Financial planners are taught that a portfolio balance of 60% stocks, 40% bonds has yielded the optimum return of growth and low volatility over the course of decades. Similar to the 30,000-foot perspective of saying that the stock market returns an average of 10% per year, this recommended balance ignores shorter-term swings and all kinds of macroeconomic effects from the business cycle to the campaigns of the Federal Reserve to mitigate crises and tamp down inflation.
Anyone with a time frame of less than 40 years to liquidate assets better beware of broad-brush statistics.
Every household has its own needs for growth, stability and availability of cash flow for routine life and unexpected emergencies. Cash flow is king. Failing to maintain an adequate emergency fund could force the sale of assets when their values are temporarily depressed. Reaching for growth usually means reaching for risk – which means loss during the inevitable macroeconomic cycles.
The Fed and Congress flooded the economy with unprecedented monetary and fiscal stimulus in 2020 and 2021. Unsurprisingly (especially including Covid-related supply-chain restrictions) this caused inflation.
Monetary stimulus caused “everything bubbles” in stocks, bonds, real estate, crypto currency and other bizarre investments (like SPACs) which are symptomatic of a “high fever” in speculation. I recognized the classic bubble since it resembled the 2000 dot-com bubble and many other historic bubbles. I sold almost all my stock holdings, especially S&P 500 funds which had a concentration of overvalued tech stocks.
Every METAR knows that the Fed’s program of raising the fed funds rate and QT in 2022 caused both the stock and bond markets to tank at the same time. But are the bubbles completely deflated at this time?
Stocks Haven’t Looked This Unattractive Since 2007
The allure of shares dimmed when bond yields surged and the corporate-earnings picture continued to darken
By Eric Wallerstein, The Wall Street Journal, April 6, 2023
The reward for owning stocks over bonds hasn’t been this slim since before the 2008 financial crisis.
The equity risk premium — the gap between the S&P 500’s earnings yield and that of 10-year Treasurys — sits around 1.59 percentage points, a low not seen since October 2007.
That is well below the average gap of around 3.5 points since 2008. The reduction is a challenge for stocks going forward. Equities need to promise a higher reward than bonds over the long term. Otherwise, the safety of Treasurys would outweigh the risks of stocks losing some, if not all, of investors’ money…
The Federal Reserve now faces the dual challenge of raising interest rates to cool inflation while reaching into its toolbox to prevent a full-blown banking crisis from erupting — both of which cloud the outlook for stocks…
Value stocks are “dirt cheap” relative to growth, now more discounted than they have been four-fifths of the time in U.S. stock-market history…When inflation has run between 4% to 8% a year, value stocks have outperformed their growth peers by 6 to 8 percentage points annually… [end quote]
Both the bond and stock markets are behaving as if happy days are here again.
The stock market has plenty of animal spirits. Even the slightest hint that the Fed will pause raising the fed funds rate causes a pop. The stock market has been in a channel with minor noise for months. (Up about 6% in 2023 but no sign of a true bull market.) Traders are shrugging off the possibility of recession which would depress earnings. The CAPE has dropped a little from its bubble high but stocks are still overvalued.
Meanwhile, the bond market is convinced that the Fed will conquer inflation decisively. The 5 and 10 year breakeven inflation rate is 2.25%. The Treasury yield curve has dropped since the banking crisis as the Fed added to its assets, largely reversing QT. The inverted yield curve shows that the bond market has been expecting a recession for many months now.
If inflation stays in the range of 4% to 8% for an extended period of time, the bond market will be surprised in a bad way. Real (inflation-adjusted) yields are still negative and would become even more negative. The Federal Reserve would be forced to raise the fed funds rate even in the teeth of a recession. They would figure out programs to protect banks with large Treasury holding, but many smaller banks don’t have Treasuries but do have C & I portfolios (commercial and industrial loans) that would be vulnerable to defaults in a recession.
I have CDs maturing in 2023. Where to re-invest? I’d like to buy stocks but I still think they are overpriced. I think the stock and bond markets are both overly optimistic.
Bond yields, including TIPS yields, have been falling. I don’t see anything I really want to buy.
I’m not sure what to do.