Stock, bond investors see things differently
In a nation bitterly divided along political lines, it shouldn't be surprising that stock and bond investors also appear to embrace starkly different versions of reality.
Despite heightened volatility in recent weeks, most major equity market benchmarks are back to within striking distance of their all-time highs. Meanwhile, U.S. government bond yields have fallen to near all-time lows.
Two markets, two messages, with stocks signaling a continuation of the decadelong expansion and bonds warning of potentially serious problems ahead.
Which to believe?
As striking as those divergences have become since the beginning of the year, it is possible to manufacture a benign explanation.
Normal response
Corporate profits are up by 20% from mid-2018, and both the earnings and dividend yield on large-cap U.S. stocks are significantly above those available on bonds. Historically, that yield configuration has driven money into equities.
Conversely, plunging bond yields might simply reflect expectations that the Federal Reserve will continue to lower short-term interest rates, a process that could eventually reinvigorate growth. And by itself, the apparent need for lower official rates might only indicate falling inflation expectations, accompanied by no worse than an economic slowdown.
To the mix, add in the divergence between economic and market conditions in the United States and abroad. With Asia slowing and Europe teetering on recession, investors seeking even a modicum of growth have few choices but to buy U.S. stocks.
Those seeking income face a similar choice.
By one estimate, at least $17 trillion of global government debt trades with a negative yield. In other words, investors are paying lenders to hold their money. In Germany, for example, the 10-year bond (or Bund) currently yields a negative 0.5%. By comparison, the 1.8% yield on 10-year U.S. Treasuries doesn't seem so skimpy.
Reasons to be cautious
But not all explanations are quite so reassuring.
Large-cap U.S. stocks have received a boost from share buybacks, in which businesses purchase their stock in the open market — thus supporting the share price — rather than investing in new plant and equipment. According to the investment bank Goldman Sachs, S&P 500 companies are on pace to buy back over $900 billion of their own shares before the year is out.
There also are legitimate concerns about the U.S. economy itself.
Though consumer activity and balance sheets appear strong, the factory sector contracted in August as a consequence of the trade war. In past business cycles, manufacturing typically has been the more reliable indicator of future economic weakness.
Finally, some investors appear to be operating under the assumption that policymakers in the U.S., Britain and China will act responsibly. That could be an expensive mistake.
If not for the resurgence of geopolitical risk after a multidecade period of relative calm, there would be no reason to suspect that global growth would be under serious threat. But the potential for economic disaster stemming from a nodeal Brexit, an escalating trade war or violent Chinese intervention in Hong Kong appears to be reflected only in bond yields, not equity prices.
Thrown for a curve
But back to the original question: Which of the two major financial markets — equities or fixed-income — has been the more accurate in predicting economic downturns?
Using the main predictive gauge for each asset class — a bear market for stocks and an inversion of the 2year/10-year Treasury yield curve for bonds — the fixed-income market has been more accurate over the last 40 years.
Since the mid-1970s, each inversion of the Treasury curve has presaged a recession. By contrast, stocks experienced a bear market without a recession on one occasion (1987), failed to forecast the 1980 or 1990 recessions entirely and generally have been much slower to react to looming economic weakness than their fixed-income counterparts.
There's a catch to all this, however, and it's an important one.
The Treasury curve inverted an average of 13 months before the last five recessions, while stocks, with the exception of the 2001 recession, continued to grind higher until shortly before the downturn began. That means that bailing on stocks immediately after a curve inversion usually would have resulted in leaving significant money on the table. Like now.
In deciphering what the markets are telling us, it's not just what is said, but when it's said.
Tom Saler is an author and freelance financial journalist in Madison. He can be reached at tomsaler.com.