The S&P 500 is up 40% over the past twelve months. Year-to-date the S&P is experiencing its best year since 1997. Investors have greater confidence that a recession is no longer imminent. The recent cut in interest rates validates the hope that inflation will continue to trend lower. The combination of declining interest rates and rising earnings expectations is fueling the spectacular increase in stock prices.
The misery index is an economic indicator that helps determine how the average citizen is doing economically. The misery index is simply the sum of the unemployment rate and the annual inflation rate. It’s based on the idea that inflation and unemployment both create substantial challenges for a society. It reached a high in the 1970s and into 1980 when inflation and unemployment skyrocketed. More recently, it spiked due to rising unemployment during the pandemic, then it rose due to the supply shocks that resulted from the pandemic. Since 2022, it has steadily declined to a level that it has rarely reached since the 1950s.
This remarkable economy is not reflected in the current Economic Confidence Index. Current levels of economic confidence are more in line with the crisis years of 2008 and 1992 than the boom years of the late 1990s. It’s not clear why there is a disconnect between the current economy and the public’s perception of the economy. It’s probably due to a lag between the economy’s improvement and the public fully feeling the change, which suggests that optimism and confidence are going to improve over the next year.
Markets tend to peak during periods of “irrational” exuberance and euphoria. They typically bottom out when investors are most hopeless. The current period feels somewhere in between. Investors are certainly not panicking. We are heading into the third year of a bull market, but investor sentiment still seems somewhat skeptical. That’s probably a good thing.
It is said that the market climbs a wall of worry. This occurs as more investors become confident that the rally is sustainable. As long as the economy maintains its slow but steady growth, investor confidence should only improve, causing stock prices to increase.
Corporate Bonds Reflect Economic Confidence
Bond owners are much more confident in the strength of the economy than the public. If bond investors think there is a chance that the bond could default for any reason, interest rates increase relative to U.S. Treasuries. The credit spread is the difference between a corporate bond yield and the yield on U.S. government bonds with similar maturities.
Defaults tend to occur during times of economic weakness. When economic storms are brewing, the bond market is typically the first group to sense a deteriorating economic climate. Right now, there are no signs of bad economic weather. You have to go back to 2005 to find a time when corporate bond yields paid such a small risk premium relative to Treasuries.
Most of our clients have a majority of their assets in stocks. The bond portfolio acts as an offset to the stock allocation. Generally, when stock prices decline substantially, the economy goes into a period of economic weakness. The weaker economy causes inflation to decrease. When inflation decreases, so do interest rates. As interest rates decrease, bond prices go up. While we wait for bonds to mature, our clients earn interest payments from the bonds. Bonds typically move in the opposite direction as stocks. When stocks go down bonds go up. If bond prices are stable, then the return equals the current yield on the bond portfolio, which is currently about 5%.
At the beginning of the year, we projected that as interest rates fell, bond prices would rally substantially. We got the direction of interest rates correct. Interest rates are falling, but the magnitude of the decline is not as significant as we expected. This is a result of the surprisingly strong economy.
Investors that own both stocks and bonds shouldn’t mind this outcome too much, as bonds have still turned in a respectable performance. The total return for our bond portfolios is about 5.5% year-to-date. Once the economy eventually slows down, we should see bond portfolio returns somewhere between seven and ten percent.
Impact of Election Outcome on the Stock Market
There is a lot of talk in the political world about what will happen to the economy if the wrong side wins the election. You can pretty much ignore any political fearmongering over the future of the stock market. History suggests that there is very little connection between the party that controls the government and how the market performs.
The preceding chart shows the difference between investing with one party versus investing independent of who is in office. Investors only hurt themselves when they move out of the market based on political concerns. Focusing on what you can control is key when investing for the long-term. It’s all about time in the market…not timing the market.
A lot of people will be very upset with the election outcome. Regardless of who wins, the reality is that we will get to do this all over again in another four short years! Staying invested, regardless of who is running the government, has been the better financial move. It can be hard, but it’s really important not to allow personal feelings about politics to interfere with your financial plan. Most of the time, the market tends to rally after an election regardless of which party wins. Once an election is finished, a major source of uncertainty is out of the way.
Despite how it seems like our parties are further apart than ever, in terms of economic policy, there is actually much more consensus than there was thirty years ago. Both parties are increasingly comfortable with deficit spending, and with preserving social security and Medicare. The Biden administration kept most of the Trump administrations tariffs in place. The biggest area of disagreement is on immigration, but even in this contentious area things aren’t as different as they seem. The Obama administration deported more immigrants than the Trump administration.
Perhaps the most consoling feature of our government is that no matter who wins, radical policy change is exceedingly rare. Change is slow even during the periods when one party controls the presidency, the house and the senate. It often takes decades to change one aspect of entrenched policy. That’s the nature of our democracy, for better or worse. No one ever wins more than a round or two at a time, and score is never final.
