11/11/22
What a Reaction!
The equity market has been rallying for four weeks. Initially, the rally was supported by a combination of oversold conditions and better than feared corporate earnings. Then came yesterday’s favorable Consumer Price Index (“CPI”) report. Lower than expected inflation caused a dramatic drop in interest rates. The 10 Year Treasury bond yield fell a dramatic 28 bps to 3.81% and the equity markets surged in equally dramatic fashion. The S&P 500 rose +5.5% and the Nasdaq soared 7.4% in just that day.
The Drivers
CPI for the month of October was 7.7% (down from 8.2% in September) versus consensus expectations for 7.9%. This solid beat was surely good enough to move markets higher. Contributing to the extreme magnitude of these moves was overly bearish positioning. The put/call ratio of the S&P 500 reached a record high on Tuesday that even exceeded the prior high set at the onset of the Pandemic. When the put/call ratio is high it means that investors are expecting the market to decline with a high probability. The mid-term elections likely played a role in this bearish posture. However, it left the market unprepared for the CPI report to be significantly lower than expectations. In market parlance, the market was way “offside”. Selling those puts and covering short sales were likely culprits of the exaggerated moves.
Positioning
What does this mean for portfolio positioning? Recall our framework below. Over the last few months, we have become increasingly bullish on Fixed Income as growing disinflationary trends appeared in the economy and, therefore, we surmised interest rates were nearing a peak. The sell-off in the bond market created a generational opportunity to obtain attractive yielding securities in investment grade bonds.
The next stage in reaching a new market cycle likely requires interest rate stabilization. Yesterday’s CPI report would appear (for now) to have arrested expectations for higher interest rates. It is even possible that interest rates have peaked, which is a further bullish sign for bonds. A stabilization in the interest rates even at current levels would create an excellent environment for much of the fixed income universe.
What this means for equities is less certain. Not surprisingly, and as we predicted in our framework, growthier technology stocks – the ones that have been severely beaten down over the last year as interest rates climbed higher – are having the biggest bounce. Lower interest rates are indeed positive for stocks. However, there remains the looming possibility of a recession that would likely negatively impact corporate earnings. Inflation may be in decline but one reason for that may be due to demand destruction, which is evident in the housing and durable goods sectors. Therefore, the bounce stocks are currently experiencing could be short-lived depending on their earnings outlook.
The earnings outlook for stocks will likely differ industry to industry and company to company. Stock selection as opposed to simply increasing overall equity allocation remains key to participating in these bear market rallies while offering some protection against a fading economy. It is tempting to think that is the time to take a lot more equity risk, but it is not. Rather, it is time to remain patient and to carefully pick our spots.
Conclusion
While we assess the economic landscape with some trepidation and remain very selective on stocks, high quality bonds now offer a refuge. With substantial yields and interest rate stabilization, bonds currently offer equity-like return potential without carrying as much economic risk. As we patiently wait for an anticipated earnings outlook stabilization, we are content to stay balanced, protect portfolios and prepare to capitalize on opportunities.
Rick Lear Jim Warner
Chief Investment Officer Head of Research
Co-Portfolio Manager Co-Portfolio Manager
Disclosures
LIM is a Registered Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with a superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to it market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
U.S. Treasury securities are guaranteed as to the timely payment of principal and interest if held to maturity. Investment options are neither issued nor guaranteed by the U.S. government.
The Bloomberg Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Bloomberg U.S. Investment Grade Corporate Bond Index covers U.S. dollar denominated, investment-grade, fixed ratee or step up, taxable securities sold by industrial, utility and financial issuers. It includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity and quality requirements. Securities included in the index must have at lease 1 year until final maturity and be rated investment-grade (Baa3/BBB-/BBB+) or better using the middle rating of Moody’s, S&P, and Fitch.
The Bloomberg US High Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. A small number of unrated bonds are included in the index. The index excludes emerging markets debt.
Bloomberg Commodity Index is comprised of futures contracts and is designed to be a highly liquid and diversified benchmark for commodity as an asset class.