Last week, I mentioned that the first anniversary of the bull market was celebrated on October 12, 2023. But how will stocks perform in year two?
The second year of a bull market typically sees positive returns. The chart above illustrates the percent returns in the 12 months following the first anniversary of a bull market (on the horizontal axis) compared to the percentage gained in the first 12 months (on the vertical axis). Of the 22 occurrences recorded, only three were negative. Eighty-six percent of the time, the returns were positive for stocks in the second year of a bull market, with the bulk of those years experiencing double-digit gains.
And, as discussed a few weeks ago, there were other historical, technical, and fundamental reasons to expect a year-end rally that extends into 2024. In that column, I suggested the possibility that I would “make some changes to my investment portfolios to get more in line with a possible rally in the equity markets for the remainder of the year.” I added, “If I do, I will let you know.” I did make some changes, which I will list at the end of this column.
What will be the Fed’s next move?
The Federal Reserve meets next week to discuss what they will do with the federal funds interest rate. They last raised rates during their July 26, 2023 meeting. That hike was the 11th in a rate-hiking campaign that brought the Fed’s interest rate from a range of 0 to 0.25 percent in early 2022 to its current range of 5.25 to 5.5 percent. At that point, I said they were done raising rates. However, I did offer there was a chance of an alternative. After all, the Fed contends that they are “data dependent” when setting monetary policy to fight inflation.
Since July 2023, economic data has been robust, and inflation stopped its decline. Both, by themselves, should be enough data to support yet another interest rate hike by the Fed at its next meeting. But they won’t, according to the probabilities listed on the CME FedWatch Tool.
The reason for the pause? Some members of the Federal Reserve have cited that rapidly ascending higher interest rates in the bond market are doing some of their work for them, thus requiring less tightening action by the Fed.
That doesn’t mean the Fed is definitely done for this cycle; after all, Fed Chairman Jerome Powell points out that inflation is still too high and that the resilience in the economy and the strength of the labor market indicate that a return to two percent inflation will require below-trend economic growth and weakness in the labor market. That could mean leaving interest rates high for a very long time, or even raising rates.
Still, I believe the Fed is done raising rates based on Beige Book anecdotes. The Beige Book is a Fed publication about current economic conditions across the 12 Federal Reserve Districts. I like it because it is data in story form—anecdotes.
The plural of anecdotes is NOT data. However, the origin story for data is anecdotes. And the anecdotes in the Beige Book reveal concern. I suspect that those high interest rates will be the reason behind more tales of sluggish economic activity. Those stories will eventually become weak data. Inflation has been cut in half over roughly the last year. The softness of that data would cause further disinflation. The good news is that in that instance, we can be even more confident that the Fed will stop raising rates. The bad news is that this would probably be the start of a recession.
What is behind the rapid rise of the yield on the 10-year Treasury Note?
The 10-year Treasury Note hit five percent this month. That is up from 3.3 percent during the mini banking crisis of March and April 2023, when Silicon Valley Bank and other banks collapsed. And it is up about one percentage point since the Fed’s July 2023 meetings. Why has the 10-year Note skyrocketed? To explain that, we can deconstruct the 10-year Note.
The yield of the 10-year Note is the sum of inflation expectations, expected short-term interest rates, and the term premium. The “term premium” is the higher amount of return required by an investor due to the increased possibilities of known and unknown risks that threaten the viability of the investment over that longer duration. So, what happened since July 2023 to shoot up the yield of the 10-year Note? Let’s consider each of those three components:
- Inflation expectations. That has mostly stayed the same. Let’s just call that a zero effect to keep it simple.
- Expected short-term interest rates. Earlier in 2023, and for a long time before that, the crowd was convinced that a recession was imminent. As a result, that same crowd expected the Federal Reserve would have to cut interest rates by mid-2024 to support the economy. However, since then, I have cited several times that more investors, pundits, and economists no longer expect a recession to begin in the next 12 months. That has erased the expectations of an interest rate cut, which has added about a one-half percentage point increase to the 10-year Note.
- Term Premium. Some of the Term Premium includes unknown long-term risks emanating from the Russo-Ukrainian and Israeli-Hamas wars. The rest of the term premium spread can be blamed on the U.S. government—or, more precisely, the lack of government. Up until October 25, 2023, when Mike Johnson was elected Speaker of the House, the U.S. was unable to govern for three weeks after the previous speaker, Kevin McCarthy, was ousted. It is arguable if Congress can prevent a U.S. government shutdown by November 17, 2023, when it will no longer be funded. The world is burning, and our leadership is absent. That has added about a one-half percentage point increase to the 10-year Note.
Expected short-term rates should stabilize and, if anything, tick down due to the Fed likely being done raising rates in this cycle.
The term premium should also narrow as the military conflicts become more predictable and a speaker is elected to help pass a continuing resolution to fund the government. Both of those things may take months to occur. Still, even if the 10-year Note spikes to 5.3 percent for a brief period, that narrowing of the term premium should bring the yield back down to about 4.8 percent.
Keep in mind that that is a bold call. A 4.8 percent yield on the 10-year Note is abnormal—and not for the reason you might think. Over the past 50 years, the 10-year Treasury yield has averaged about six percent over the last 50 years.
Knock knock
My call for an NBER-defined recession to begin by March 2025 reminds me of a joke.
How do you know economists have a sense of humor? They use decimal points.
I am not so stupid to think I am bright enough to know exact dates or even think I will be reasonably accurate without a heavy dose of luck. But here is why I must try to figure it out: If the risk of a recession is some 16 months away, it allows me to feel more confident in holding equity positions now. However, if a recession is penciled in for 2025, perhaps a year from now I will de-risk portfolios to emphasize capital preservation.
The inverse of predicting a recession by early 2025 is that I do not expect an imminent negative turn for the economy. In that case, I have time to adjust portfolios, anticipating a stock market rally through year-end 2023 and into 2024. And that is what I did. I made some changes to my investment portfolio. Broadly, those trades were designed to:
- Reduce Defined Outcome ETFs (aka buffer funds) in favor of straight equity ETFs;
- Reduce the allocation to the Health Care Sector;
- Reduce Value in favor of Blend and Growth; and
- Introduce an allocation to the VanEck Morningstar Wide Moat ETF (symbol: MOAT) and the Vanguard Mega Cap ETF (symbol: MGC).
The MOAT ETF focuses on U.S. companies with sustainable competitive advantages, or “moats.”
This minor reallocation may turn out to be a trade that lasts a few months or a year. The odds of a recession beginning by early 2025 are high. I have kept sight of the risks.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
