October was the third straight lousy month for stocks with the S&P 500 down about 3% through yesterday. Both the S&P 500 and NASDAQ entered correction territory late last week. Small caps (Russell 2000) are down about 18% from their high in July and down 32% from their 2021 peak. Could you ever have imagined that the Russell 2000 would be down nearly one-third from its all-time high in the same week that Q3 GDP came in at just under 5%?
Much of the blame for the weakness for the S&P 500 and NASDAQ has been chalked up to higher interest rates and disappointing earnings guidance from companies, but the geo-political situation hasn’t helped. Can you blame management teams for being cautious on guidance when an escalation to the war remains a real possibility? And now the U.S. has bombed terrorist munitions depots in Syria. That doesn’t sound like a situation that is de-escalating.
So for now, the much anticipated fourth-quarter rally in stocks is on hold. It will be hard for the downward trajectory in stocks to change course without interest rate stabilization or easing tensions in the Mideast. Our view is that interest rates may stabilize here, but geo-political unrest is likely to continue.
We are about halfway through earnings season at this point. While the results haven’t been bad, guidance and stock price reactions to results have been very poor. As we mentioned in the previous bullet point, companies are understandably nervous giving earnings guidance with geo-political tensions growing. Some key companies (Tesla, Google, Facebook, and Chevron among others) have given weaker than expected guidance that shook the stock market. Significantly more companies are lowering guidance than raising guidance.
Companies reporting better-than-expected EPS or sales have only seen marginal rallies in their stocks, but companies that miss on either of those metrics have been slammed.
We and many others expected a better earnings season. Earnings may not, in the short-term, be the pillar that stabilizes stock prices. Not only are managements concerned about the Mideast, but there are also growing calls for a significant slowdown in our economy. It is no wonder future expectations are so cloudy.
WHEN WILL INTEREST RATES STOP RISING?
The correction in stocks since the late July highs has been attributed primarily to a spike higher in interest rates. The surge in yields started with an announcement from the Treasury Department in early August that it would be forced to increase bond issuance in order to fund deficits from higher government spending. The rise continued as Q3 economic growth surprised many economists’ forecasts to the upside. Third-quarter GDP was reported at a blistering +4.9% annual growth rate.
What is driving the selling of bonds pushing rates higher? (The 30-year Treasury bond yield has risen 123 basis points since July 19th.) While Fed Chair Powell rejects sticky inflation as a cause of the yield rise, he offered three possible explanations: quantitative tightening, a strong economy, and market worries over deficits. To be sure, the economy is strong, and investors are worried about budget deficits, but the recent increases to the Fed’s balance sheet are not consistent with history.
At some point, the value proposition of long-term rates will start to attract investors. Four percent long-term yields were too low for that attraction, but 5% represents a significant increase in risk premium that could be viewed as very appealing. With long-term Treasury bonds down 52% from 2020 highs (proxied by TLT, the 20+ year Treasury Bond ETF), we have come a long way already. Assuming a return to 2% inflation, near 5% ten-year Treasury yields offer almost 3% compensation to account for inflation risk and real growth rates. It is hard not to find rates attractive at these levels.
The most recent Barron’s issue was titled ‘Time to Buy Bonds.’ We agree. Although with a flattish yield curve, short-term and medium-term bonds yield about the same as long-term bonds. But for an investor willing to accept more interest rate risk, it may be time to lock in today’s rates for longer.