Searching for Goldilocks

Watching the stock market these days is very easy, but also very frustrating. Good news is bad news and vice versa. Case in point was Friday’s employment report. Nonfarm payrolls increased by 372,000 in June, well above the 250,000 Street estimate and the unemployment rate remained at 3.6%. What was the reaction to this good news? Stocks dropped and bond yields rose. Go figure.

The chart below shows where the increases originated, primarily in services, which coincides with our view that the ‘goods’ inflation we’ve experienced is beginning to wane. But the services side was quite strong, especially in leisure and hospitality, which implies that the consumer is still spending, despite higher prices.

The essential problem is that markets… all markets… are desirous of a Goldilocks scenario. Economic data that is too strong, like Friday’s employment data, implies that the Fed will continue to raise rates. That increases the chance that they raise rates too much, creating a recession. By the same token, economic data that is too weak, implies that the Fed will ease up on rate increases too quickly. That risks stagflation (slow economic growth with inflation). Everyone wants the data to be ‘just right’. Not too hot, and not too cold: the Goldilocks economic scenario.

The promise of Goldilocks economic conditions is a scenario that corrects inflation, without causing the economic pain of a recession. Surely, this is the proper target for the Fed, but one that has a low probability, as we’ve discussed many times. The gyrations you are seeing in markets each day are largely a function of the data flow. Our suggestion is not to get too caught up in the daily gyrations and focus on the longer-term. This is why PWM employs well diversified portfolios, seeking to mitigate short-term portfolio gyration while keeping our eye on the long-term objectives.

Did you notice the change?

In the midst of all the market gyrations over the last several months, there has been one very important change that has gone largely overlooked: the growing attractiveness of bonds. As interest rates rose over the last several months, the bond market was pounded, producing the worst start to a year for the traditional 60% stock/40% bond portfolio since 1970.

What does that mean for valuations? First and foremost, it implies that bond valuations, which have been extremely high for a long time, are now very competitive with stocks. The relative attractiveness of bonds versus stocks has improved in a meaningful way. The chart below shows the yield of the 10-year Treasury note and the dividend yield of the S&P 500 going back to 2009. The yield on the Treasury note in excess of the S&P 500 reached 1.36%, which is the largest it has been since 2010. It may be that both stocks and bonds remain overvalued, but the relative attractiveness of bonds should be getting more attention.