Friday made it five-for-five as an employment report weaker than expectations pushed bond yields lower and stock prices higher.
August, September and October were three miserable months for investors. Although the economy remained strong and inflation continued to come down, longer term bond yields soared as both investors and central bankers fretted about the enduring economic strength despite tightened monetary policy. In addition, swelling deficits worried bond investors concerned that demand for new bond issuance would be insufficient, given the enormous needs of government. As October came close to the end, both the NASDAQ and S&P 500 were in correction territory while the yield on 10-year bonds was closing in on 5%, an increase in yield percentagewise of close to 35% in just three months.
Then, suddenly, stocks roared, rising close to 6% in a week while the yield on 10-year Treasuries fell by almost 50 basis points. Assuming the economy didn’t suddenly change course, what could cause such a sudden reversal?
1. The selling had been overdone. Higher long-term rates put downward pressure on stock prices, more so on high P/E stocks. The high-flying tech stocks that led the market up gave ground. Without leadership, most other stocks followed. Over time, the selling pressure accelerated. As often happens in corrections, emotions start to trump reality. Investors caved in to fears that a correction might evolve into a bear market. They sold and raced into the safety of money market funds.
2. The Fed changed its tone. At the September FOMC meeting, the Fed firmly backed the idea that a soft landing was more likely than not, meaning that while no recession was in sight, it would take longer to bring inflation to its 2% target. That meant interest rates would stay higher for longer. That thought put upward pressure on long-term rates which, in turn, put downward pressure on equities. At last week’s meeting the message was that higher rates were effective enough, at least for now, negating the need for another Fed Funds rate increase.
3. Stock buybacks – missing in action. Stock buybacks have been a large source of demand for years. But there are times companies are not permitted to buy back stock. One such time is prior to the release of market moving news, specifically earnings reports. Thus, since most companies are on December fiscal years and report third quarter earnings in mid-late October, the underpinning offered by stock buybacks disappeared and the emotional selling pressure increased. It is unreasonable to label what we witnessed in October as a panic. But markets were oversold and would have benefited from the persistent buying power of corporations.
4. The mutual fund fiscal year ends October 31. This happens so that dividends and realized capital gains payments can occur before the end of the calendar year. Funds often undergo “window dressing”. The October 31 year end statement paints a picture at a moment in time. Fund managers like to show a portfolio of good acting stocks, not names that got creamed in 2023. So, in October, many sell their losers and add to their winners.
5. Tax selling – No better time to take losses to offset realized gains than in the midst of a correction. If you like the stock long-term, you can always buy it back in 31 days.
6. War, Congress, and the Threat of Government Shutdown. – This is pretty far down the list because wars, Congressional foolishness and partial government shutdowns rarely have a significant economic impact aside from a few industries like defense. As October came to an end, the fears of rapid acceleration in war activity started to calm down, the Republicans finally elected a Speaker, and the likelihood that they would shoot themselves in the foot yet again by shutting down government faded. It didn’t disappear totally given the inability of Washington to come to consensus on anything.
7. Economic news confirmed a slowing economy and the likelihood that inflation will continue to slow. Friday’s report that the workforce grew by only about 50,000 jobs, net of prior months’ adjustments, modestly increased the slack in the workforce. The unemployment rate of 3.9% has been rising slowly over the past several months without significant layoff announcements suggesting much more cautious hiring.
8. Treasury borrowing needs are rising but it is choosing to shorten duration of what it offers. With the yield curve almost flat and long rates significantly higher than they were three months ago, Treasury, at least for now, has decided to issue more shorter-term debt instead of Treasury bonds maturing 10-years out or longer.
All the above is well and good. But where do we go from here? I have said for months that equities are slaves to the bond market. With growth moderating and earnings slowly improving, the big catalyst for equity price movements has been sharp changes in bond yields. Last week, of course, the movement was down for rates and up for equities. The term rate had risen well above zero before backing off a bit. Obviously, the success of the late fall Treasury auctions will have a lot to do with the forward path for equities.
What has changed, at least for now, is the mood of investors. That is characteristic of market bottoms, even moderate corrections like the one we witnessed over the past three months. That’s why so many bottoms are V-shaped. Investors are also forward looking. Today they should be focusing on the end of 2024 and beyond. That assumes no sudden cataclysm in the interim. At the moment, none appears likely. Whether there is a soft landing or modest recession shouldn’t matter all that much if a bottom happens within 2024. To me at least, a 4.5% 10-year Treasury yield, against a backdrop of slow growth and moderating inflation seems reasonable. Reasonable means I can justify a 10-year rate anywhere between 4-5%.
If bond volatility subsides and earnings grow modestly, the backdrop is for a slowly improving stock market. Those 30%+ gains that sometimes happen shortly after a real bear market ends are unlikely. First, the correction this time was rather modest. Second, valuations today are fair but not salivating bargains. It won’t take much more than a 10% rally to rid to market of bargains.
In summary, I think the lows of late October will prove to be the lows for some time. But within a softening economy, it’s too early to scream all clear, especially when bargains aren’t very prevalent. As the market reversed course last week, the early instincts were to dive back into the high growth, high volatility names that have been market leaders for the past several years. But unless interest rates fall a lot further, valuation will be a headwind for many of these favorites to march to new highs. At the same time, there are plenty of economic trouble spots. Banks still face low loan demand, rising defaults, and increased regulatory pressure. Housing is going to be impacted by high mortgage rates for some time to come. As auto dealer lots fill, demand will be hurt by similar high financing costs. Many companies in the health care segment continue to reel from declining demand for vaccines and test kits. The strong dollar hurts exports, and China faces many economic hurdles. Offsetting all this is strong spending by consumers. With unemployment still less than 4%, people will spend as long as they keep earning money.
The wind is at the backs of investors but future growth will moderate quickly from last week’s sharp gains. With that said, stocks should resume a path similar to history whereby annual gains averaging 7-9% will prove better than bond returns of 5% or less.
Today, Emma Stone is 35. Sally Field turns 77.
James M. Meyer, CFA 610-260-2220