Equity markets have begun the year in positive territory, continuing the move that started in early November. This is the result of investors projecting additional stimulus on the back of a Biden presidency and a Democrat-controlled Congress. We are seeing money move into cyclicals like transportation, industrials, and energy. This has occurred at the expense of big tech, which may be adversely impacted by tax increases going forward. Financials are also beginning to outperform because of rising interest rates.
We commented several months ago that we believed earnings were beginning to turn around and that we would be watching to see if the bull market would resume. Specifically, at that time we were looking for outperformance in the equal-weight S&P 500 index (RSP) versus the market-cap weighted index (SPY). We wanted to see sectors of the real-world economy get some money flow, after many months of serious underperformance. We also pointed out that we were looking for yields to rise and break out above 80 (see our Weekly Market Commentary from October 5, 2020) as a first sign of growth going forward. Finally, we have been watching for the financial sector to come back to life. It is hard for a bull market to exist without strong participation from the banks. We stated that new highs could not be reached on the back of big tech alone. Well, you can now check off every one of those criteria as having occurred. We are again at all-time highs by the broad indices and, more importantly, this time it is supported by stronger breadth across the economy. It appears that a new bull market in equities has begun in anticipation of corporate earnings turning positive. Implicit in what we are seeing is also the foreseeable end to COVID-19 as a major deterrent to our lives and activities. This currently seems like a far-fetched idea given the extent of the infection in the United States right now, but markets have an incredible ability to see the truth when it is otherwise hidden. The collective wisdom of millions of investors across the world is real.
The temporary downside to all this is that “safe” fixed income assets, including bonds, dividend payers and other interest-rate-sensitive sectors have taken it on the chin as interest rates have jumped 40 basis points in three short months. The 10-year Treasury yield jumped 20 basis points in the past 10 days alone! The big reset in rates causes those safe assets to sell off as investors look to new purchases at higher yields. Remember, bond prices and yields move opposite each other. As such, investors are getting a taste of the downside to investing in so called “conservative” portfolios. They don’t seem nearly as conservative in a rapidly-rising-rate environment. This is one of the big benefits to having dynamic portfolio allocation. Dynamic allocation allows for reallocation in response to what really matters, which is changing economic fundamentals.
Ultimately, interest rates need to rise if we are going to return to economic growth and a semblance of normalcy. We don’t make predictions, but we are hopeful that prices are reflecting what will come out of the next couple of earnings seasons. We will continue to take it a day at a time.
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