The pundits who watch bubblevision see the S&P 500 going to new nominal highs, while those who watch the tapes know better – that we are exactly where we were 10 months ago.
Since that time, all your portfolio has done is pick up the dividend – the total return in the stock market is just 2 per cent. Go to the bond market, and the 10-year T-note has generated in excess of a 10-per-cent total positive return in the same time frame.
Even within the S&P 500, the sector composition has a recessionary feel to it. Since first hitting 2,900 back in August of last year, the best-performing sectors have by far been the ones you want to own in a lower growth/lower rate environment – utilities (plus 13.3 per cent), real estate (plus 12.9 per cent), consumer staples (plus 8.6 per cent), and communication services (plus 5.6 per cent). The sectors that have lagged the most – in fact, declined outright – were energy, materials, financials and industrials. So maybe the stock market and the bond market aren’t telling divergent stories, after all.
The last time we had bonds outperform stocks to this extent, at the same time that utilities outperformed the SPX by such a margin, at a time of a flat-to-inverted yield curve, was back in January, 2008. Do we need to say any more?
As for the U.S. Federal Reserve, it seems highly likely that we see a 50-basis-point rate cut at the next meeting on July 31. Everyone seems to think this is aggressive, yet the first easings in the past two cycles were 50-basis-point cuts. It’s hardly out of the ordinary. In any event, here’s what history teaches us: The Fed eased for the first time on June 6, 1989, and the recession still lurked out there, although it took a year.
The lags were much shorter on the past two go-rounds – the Fed first cut on Jan. 3, 2001, and the recession nobody saw coming started in March, 2001. The Fed cut rates for the first time on Sept. 18, 2007, and the recession that everyone was convinced was only going to be a “soft landing” commenced in December, 2007 – and recall that the S&P fractionally made a new high within a month of that initial rate reduction – but we know what happened next. This is the tradition of the equity market – knee-jerk reflexive move up as the focus is solely on the cure (rate cuts), and then the focus turns to the disease (the recession).
So, we are replaying history here. In the lead-up to the initial rate cut and the immediate aftermath, momentum traders took the S&P 500 up – and, on average, the market rallied 5 per cent over a one- to two-month time frame. But this was only recommended for those brave souls who like to chase nickels in front of the steamroller. After that rush following the excitement over that initial easing, the stock market slumped an average of 37 per cent to the fundamental lows.
In recessions, the Fed cuts rates an average of nearly 500 basis points and never less than 200 basis points. This means we are going back to that “effective lower bound” as the Fed likes to put it – a round trip back to zero, and quite possibly lower than that. I can easily see the 10-year Treasury note yield converging on Britain’s levels of 0.8 per cent – the curve will steepen and melt at the same time. But, as we have seen in these prior three “balance sheet” recessions, it takes incrementally more firepower out of the central bank to reverse the tide. We have already seen research out of some of the Fed district banks over negative rates, a renewal of quantitative easing and interest rate targeting out the curve. Either way, bond yields are going to stay on their downward path.
The fastest-growing segment on banking-sector balance sheets are Treasury securities, and by a country mile. Not just that, but there is another very bullish dynamic for Treasuries evident in the Commitment of Traders reports. Two weeks ago, the net speculative short position on 10-year Treasury notes (on the Chicago Board of Trade) was 434,970 contracts. Last week, this was cut to 324,470 net short contracts. These speculators are hurting bad and being forced to cover. This alone is a very powerful source of de facto buying support for bonds.
If you have to be fully invested in equities, stick with what has worked in this round trip to the highs – which means exposure to those sectors most highly correlated to this sustainable declining path in long-term interest rates. This includes utilities, telecoms, pipelines and real estate investment trusts.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.