For the past week, the market has been on a wild roller coaster ride. The are several causes for the tergiversations, paramount of which is the unpredictability of Federal Reserve policy. Since 2017, rate increases had followed a fairly unwavering 25 basis point increase in the federal funds rate each quarter. That stable and measured interest rate increase scenario has now been cast aside, as Federal Reserve Chairman Jerome Powell has indicated through a number of pronouncements — which investors have misread — that he intends to adopt a wait-and-see approach to interest rate hikes that will be influenced by frequent monitoring of economic data, instead of doctrinaire and unyielding established monetary policy.
Powell has on a number of occasions used the analogy of someone walking into a living room with the lights turned off: “What do you do? You slow down and you maybe go a little bit less quickly, and you fell your way more.” As is evident by the sudden daily changes in the market, many investors have not taken kindly to Powell’s lights out in the living room explanation.
The Fed’s newfound and unorthodox, fly-by-the-seat approach helped trigger havoc in the markets. On Tuesday, the Dow industrials tumbled 799.36 points, or 3.1%; yesterday, the Dow tumbled almost 400 points on a jobs report that showed wage gains; bond yields concomitantly rose. The 10-year Treasury note hit 2.891%.
What is transpiring and creating such distress is that the long-running quantitative easing period that created a bonanza for the stock market is over and the pricing of asset classes, which had been skewed for the past decade, is now in the process of readjustment to reflect a more traditional and realistic risk-reward paradigm. Throw into this mix a Federal Reserve that has indicated that adopting monetary policy to continue to provide generous returns to investors in the stock market is no longer its priority. After a decade of investment bliss, the transformation to a more unstable environment is difficult for many investors to process and digest.
The uncertain direction of the yield curve, the pending outcome of trade talks with China as well as softening in some economic indicators all are spurring investors to pull a portion of their funds out of the market and into cash or cash equivalents. The moment is ripe for such a reallocation into short-terms cash equivalents, particularly as the yield curve has come close to inverting. Three to six-month T-bills have returned approximately 1.7% year to date. This recent exodus of funds from the market is a dramatic shift from the zero-interest era, when bank certificates of deposit never pierced the 1% yield barrier. As long as the market was roaring with the blessing of the Fed, no investors were interested in parking their money in vehicles that yielded almost a zero return, when they could leave their funds in the stock market and reap ample total returns with minimal to no risk.
A $100 invesment in the S&P 500 10 years ago would today be worth approximately $400. Over that same period, that $100 in cash or cash equivalents today would be worth $104. That mismatch is what helped fuel the bull market. Consider now how the investment climate has started to drift away from the halcyon days of heady returns generated by stocks and an ever-increasing S&P 500.
For the first time in a decade, fixed-income vehicles have afforded investors higher returns than the market recently with considerably less risk. The 10-year Treasury note, for the first time in a decade, has been rising steadily since 2017; it now has hit the 3% threshold, where it has hovered for most of the year, which has slowly started to impact the pricing of asset classes. Many have responded by reallocating their portfolios to increase cash equivalent and short-term bond positions.
Additionally, a steady and perceptible slowdown in global growth has dragged down overseas markets. The MSCI ACWI index is down 5% since the beginning of the year. In November, for the first time this year, the S&P 500 fell into negative territory and fell behind cash for most of the autumn season, save for a recent bounce.
Another factor that will weigh on the markets likely trajectory is that corporate profits, which had seen double-digit increases close to 22% in 2018, are inevitably slated to slow in 2019. FactSet anticipates a substantially lessened growth rate of 9%. While these dark clouds continue to appear on the horizon, escalating rates on short-term cash and equivalents as well as longer-term maturities continue to offer yields that are increasingly superior to those provided when the stock market is going through a period of protracted volatility.
Perhaps a foreboding sign for the market in 2019 is that the total return of the S&P 500 in November fell behind the return available from an investment in cash equivalents.
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