Conflicting opinions are what makes markets work—you believe the price of a stock is going higher, while we think it’s not, we sell to you—but there appears to be a fairly large difference in opinion this year between stock and bond investors. Stocks have had a remarkable run since the Christmas Eve 2018 low, and have easily overcome a few bumps in the road, suggesting that stocks are telling a story of a near-term economic soft landing and a recovery shortly thereafter.
The bond market appears to be telling a much different story. The yield curve has flattened substantially, even inverting recently (with the 10-year Treasury yield moving below the 3-month T-bill yield). Theoretically, this could at least partially indicate a lack of confidence in future growth prospects. If investors are willing to have their money tied up for ten years at ever lower rates, the confidence in future economic growth is likely not particularly strong.
So which story is right?
As is often the case, there may be some truth to both stories. So far this year, the stock market has behaved mirror image fashion relative to 2018. Last year was a story of multiple contractions (lower P/Es), even though earnings (the E) were stellar. The contraction was a function of tightening financial conditions; but also, the weak outlook for 2019 earnings. Remember, stocks tend to discount the future. This year has been a story of multiple expansion (higher P/Es), even though earnings estimates (the E) have been lowered according to Refinitiv estimates. The expansion has been a function of loosening financial conditions in our view, but we’re probably at a stage now where earnings are going to have to do some more of the market’s “heavy lifting.” Stocks may be increasingly vulnerable to a pullback as investor sentiment has recently moved well back into the extreme optimism zone (a contrarian indicator). The bond market is also being influenced by negative interest rates in several international regions, which appears to be pushing investors into higher-yielding U.S. securities; while also expressing confidence that inflation will remain contained.
For now, we will call the battle between stock and bond investors a draw. The mixed picture painted above gives fuel to both sides, which is why we continue to suggest investors not chase the recent stock rally and maintain a mostly neutral–to-slightly-defensive stance both at the macro and micro level. The history lessons of late-cycle eras suggest investors need to focus on the tried-and-true disciplines of patience, diversification and periodic rebalancing while keeping an eye on long-term goals.
In the end…
Stocks and bonds appear to be at loggerheads with regard to the economic outlook, and we believe both sides have merit. Unless earnings comfortably surprise on the upside, with healthy corporate guidance, there is a risk that stocks will give back some of their recent gains. Investor optimism remains elevated, economic data has been mixed, earnings expectations are in the red for the first quarter, and persistent trade concerns all remain potential headwinds. Stay patient and diversified and stay focused on longer-term goals.