The Bond Market Problem That Is Not Going Away

/ Percension Wealth Advisors, LLC/

The bond market keeps inching closer to rare territory.

Interest rates are rising across the board. Normally this would be just fine, if not for the fact that short-term rates are rising much faster than long-term rates. This poses a unique situation/problem in the weeks ahead.

The 10-year Treasury bond rate sits just above 3.0%. The 2-year Treasury bill rate is not far behind at 2.6%. If short-term rates eventually eclipse longer-term rates (as shown below), it would mean that the yield curve has "inverted" from a traditional curve. Normally, the longer the bond maturity the higher the interest rate, and visa-versa. Take a look at how the 2-year yield (orange line) has closed the gap versus the 10-year yield (blue line):

(chart created in stockcharts.com)

Notice how quickly the short-term rate has risen relative to the long-term rate? Yield curve inversion could be near.

So is yield curve inversion bad? Potentially, yes. Last month I wrote about this dark cloud of inversion that is hanging over the market. It is often the precursor to a change in the business cycle, which can signal that economic contraction is looming, as it did in the early 2000s and 2008. Take a look at how the stock market (S&P 500, green line) reacted once short-term rates hit their apex in these previous two instances:

(chart created in stockcharts.com)

The two regions shaded in red show where the 2-year Treasury rate peaked, followed by a decline in the U.S. stock market soon thereafter. Before going any further, let's be clear: None of this guarantees that short-term rates have peaked or that the yield curve will invert. Have those odds increased? Yes.

So what would have to happen from here for those two things to occur?

For the yield curve to invert, investors would essentially have to prefer owning long-term bond investments to shorter-term bonds. This would imply that they are comfortable tying up their money for longer periods of time. Such long-term bond demand would push corresponding yields lower. Meanwhile, if short-term rates continue rising -- likely through the influence of the Federal Reserve -- eventually the 10-year rate and the 2-year rate would criss-cross and the result would be inversion.

In a perfect world, long-term rates would continue rising at a pace consummate with short-term rates until business conditions tighten. This tightening could take a number of forms, such as a decline in corporate revenues/profits, a rise in unemployment or flattening wages. As the economy reaches that cyclical peak and then starts to decline, interest rates would then slowly come back down. Lower interest rates would then (in theory) stimulate greater investment via lending and borrowing, which would lead to the start of a new economic upswing.

We know it is never this clear-cut. So if we are looking for the answer to "Is this the market top???" you are not going to find it here. What I would say is this... If the market and economy are nearing a top, I would expect stock prices to remain flat as interest rates creep higher. Eventually, financing would become too expensive and investors would pull back from investing.

But the elephant in the room that might precipitate all of this is that relationship between short-term and long-term interest rates. Long-term rates are meant to be higher than short-term rates, for the simple fact that long-term investments carry greater risk, and therefore, should pay the investor a higher interest return. But if investors decide they are willing to tie up their money for a longer period and only earn a tiny spread for doing so, the yield curve would likely invert. Then it is anyone's guess what immediate impact that has on the stock market and the economy at-large.

In The Market...

The S&P 500 fell -0.5% this past week. Let's look under the hood:

(price data via stockcharts.com)

Stocks just could not maintain the momentum generated coming off the previous week's gains. All in all it was a pretty quiet week for stocks. With interest rates on the rise, dividend-paying sectors (Utilities, Real Estate) were the worst performers. Energy and Materials were the big winners. We are still looking to buy into the Energy sector but would like to see prices come down a bit first before doing so.

In the meantime, as you see below we purchased a Consumer Discretionary fund (XLY) for many accounts. This sector appears poised to make a move higher and based on our technical evidence it made sense to try and take advantage of that.

Finally, to no surprise bonds were down virtually across the board. Long-term Treasuries and Corporate Bonds were both down more than -1.0%. We continue to own a small position in each of these areas in most accounts. I will be looking to sell our Corporate Bond position in the coming week but will likely be a bit more patient with our Treasury position.

In Our Portfolios...

What's New With Us?

I am thrilled to announce that Joshua Baird will be joining our team next month as Executive Administrative Assistant! Josh is a graduate of Pacific Lutheran University and someone I am confident will bring great value and intellect to our firm in the months ahead. I am sure you will have a chance to meet and interact with Josh once he comes on board in June.

Have a great weekend,

Brian E. Betz, CFP®
Principal

The Dark Cloud Hovering Over The Stock Market

/ Percension Wealth Advisors, LLC/

Market winds may be going through some real change following one of the stranger weeks we have seen in a while.

Just as it looked like stock prices were set to rally, they went backward Thursday and Friday. The S&P 500 index managed to put together back-to-back weekly gains for the first time since mid-February, yet the week ended on a sour note yet again. Here is how crummy Friday has been as of late:

April 20: S&P 500 Down -0.8%
April 13: Down -0.3%
April 6: Down -2.2%
March 30: (Closed for Good Friday)
March 23: Down -2.2%

Normally I would not make much of a couple days, if not for how bonds behaved in light of the late-week stock slide. Bond prices fell in tandem with stocks, which is surprising because often stock market investors pivot over to bonds when they sell stocks. Such was not the case. Both asset classes were broadly negative the past two days.

Should that persist, it spells bad things for the overall market because it means that interest rates are rising while investors see their portfolio values falling. Rising rates are fine when the stock market is stable, but stocks have been fairly volatile for almost three months running now.

One interesting thing to look at is how interest rates have risen over the past two years, specifically short-term rates. In this case, the 1-year Treasury bill. Take a look:

1-year U.S. Treasury bill yield...
Today: 2.22%
1 year ago: 1.01%
2 years ago: 0.54%

Compare this to the more tepid rise in the long-term 10-year bond rate:

10-year U.S. Treasury bond yield...
Today: 2.96%
1 year ago: 2.24%
2 years ago: 1.85%

It is unsurprising that short-term rates have gone up. That is exactly what the Federal Reserve has influenced through a series of rate increases that began in Dec. 2015 and continue to this day. But the fact that long-term interest rates have not risen at the same pace poses the risk we may eventually see an inverted yield curve.

What is the yield curve? The yield curve is pretty straightforward. The longer you lend your money, the greater the interest rate you would expect to receive in return. This creates a rising curve when charting the relationship between time and interest rates. This is normally what occurs most of the time.

For the yield curve to become inverted, longer-term interest rates would have to fall below shorter-term rates. That means investors are paid more for lending their money for shorter periods of time. If that doesn't make sense that is because it is abnormal and the exact opposite of what we want. Using the example above comparing the 10-year Treasury bond to the 1-year Treasury bill, you will notice how that gap has tightened. Two years ago the spread between the two rates was 1.31%. Today it is 0.74%.

Dark clouds forming: An inverted yield curve would be bad because it likely means a recession is coming, as it did prior to each of the past four recessions in 2008, 2001, 1990 and 1981. It can take months or years for the recession to hit after the yield curve inverts, and as we know, stock prices fall first before the economy contracts.

For now this is something to keep an eye on. It is not something to freak out about. A choppy stock market is not a down stock market. It does make our bond market investing more challenging, as conditions have weakened from where they were even a year ago.

In The Market...

The S&P 500 gained +0.5% this past week. Let's look under the hood:

(price data via stockcharts.com)

It might seem weird to read the ominous tone of what I wrote above and then see that most stock sectors were positive on the week. Last week was more a matter of starting strong and finishing weak, which is the opposite of what we want to see if forced to choose. It shows a lack of momentum heading into next week.

Speaking of weakened momentum, the below chart illustrates this concept well. I often say that what makes a positive trend is a series of "higher-highs" and what makes a negative trend is a series of "lower-lows". Notice how the S&P 500 has again peaked at a lower-high since hitting its all-time high back in late-January (the blue trend-line reflects this):

(chart created in stockcharts.com)

If the S&P 500 falls in the coming days and eventually breaks below its 200-day moving average (roughly 2.5% away) that would be very troublesome. We will respond accordingly if that occurs, but for now the market looks like it will continue moving sideways.

In Our Portfolios...

In Financial Planning...

A common feeling right now is a desire to invest more aggressively. This is to be expected when the stock market (up until February) consistently rises month after month. With that in mind, if you want to be more aggressive you need to ask yourself why...

Is it because your financial situation has significantly improved?
Is it because you feel your risk tolerance has been too conservative?
Is it because someone you trust said you should?
Is it because you simply feel like you should be making more?

Some reasons are more legitimate than others. If your finances have improved then it may very well make sense to get more aggressive. But if you have some fear that you are missing out, yet your financial position has not changed, it does not make sense.

The opposite is true too. If you feel you should invest more conservatively, is that because your financial situation has worsened or because you are simply nervous that the market will crash? The former reason is more valid than the latter.

This is where having a plan and sticking to it comes in. Those who do not plan often end up buying at the market top and selling at the bottom. I am happy to revisit your risk tolerance and portfolio allocations -- both on accounts we directly manage and those we don't. Just let me know.

What's New With Us?

I will be working over the weekend and hoping to finally clean our deck, weather permitting. As a heads up, I will be out of the office on vacation Monday, April 30th until Thursday May 3rd. I will periodically be available those days, but just know that I may not be as responsive as normal.

Enjoy your weekend,

Brian E Betz, CFP®
Principal

Are Interest Rates About To Explode Higher?

/ Percension Wealth Advisors, LLC/

Top Of Mind...

Interest rates hit a high this past week that we haven't seen in 4 years.

The 10-year Treasury yield climbed to 2.64% this week, which is higher than it has been at any point since 2014. This is the annual interest rate an investor would earn if they bought a 10-year U.S. Treasury bond today. Take a look...

(chart created via stockcharts.com)

This is a pretty important development given that long-term rates have failed to get back to pre-recession levels ever since 2009. As the above chart shows, in the past five years rates have quickly fallen anytime they approached a certain peak (the pink, dashed line). The same fate could happen again here, but I suspect we may finally start to see real increase in long-term rates after a decade of dormancy.

What does this mean? There are a few implications if long-term rates do, in fact, move higher. For one, it means bond values will go down. Second, it could spell more positive returns for the Financials sector, as banks and other firms that lend generally benefit from higher interest rates. Third, it means more expensive financing for things like home mortgages and car loans.

How this affects us: As you know, most accounts own some amount of bonds to help diversify from stocks. We would likely migrate away from Treasuries or other bonds that possess similar characteristics, such as investment-grade bonds, which we sold this past week. It could mean sitting in cash for a period of time in the event there isn't another type of bond we feel is worth owning.

We continue to own high-yield bonds in most accounts, which are a very different breed than Treasuries. I suspect high-yields will not be immune from an increase in Treasury rates, but the negative impact on high-yield bonds should be dulled compared to "safer" bonds like Treasuries.

We will continue our analysis, see what the next week brings and act accordingly.

In The Market...

The S&P 500 gained +0.9% this past week. Let's look at how the individual sectors performed:

(price data via stockcharts.com)

Another week of gains for the S&P 500, which is quickly up +5% in just three weeks to start the new year. This most recent week was more flawed though, as four of the six sectors were negative on the week. Two sectors we are looking to buy next week are Financials (XLF) or Consumer Staples (XLP). Financials continue to trend nicely higher, while Consumer Staples appear on the cusp of a new rally.

As alluded to earlier, it was another down week for Treasury bonds, which fell for the 3rd-straight week. If bonds are going to fight off this rise in interest rates then investors will need to show up soon ready to buy.

We will likely make some modifications to our bond fund lineup as well in the coming weeks. TD Ameritrade amended their list of commission-free funds, which are the ones we try to use when appropriate. I have to dig in and research the new list, but if you have any questions feel free to ask. My hope is to find a buffet of funds that are comparable to the previous ones and use those so-as to escape incurring transaction costs.

In Financial Planning...

There is one change within this year's tax reform that I had not previously touched on but is probably worth mentioning. The ability to "recharacterize" a Roth IRA conversion is no more.

A Roth IRA recharacterization is the act of undoing a Roth conversion (something I wrote about a few weeks back here). It reverses the process of having turned a Traditional IRA into a Roth IRA, and along with it reverses the tax burden you would be subject to pay on the balance converted. Many people do this if, for example, their income ends up being much higher throughout the year than they anticipated. They would rather wait for another year than pay a higher tax percentage now on the converted amount.

The old rules allowed you all the way until Oct. 15th to undo a Roth IRA conversion that stemmed from the previous tax year. Now, you cannot do them at all. I highlight this particularly because we will sometimes recommend that clients convert a portion (or all) of their tax-deferred IRA balance into a Roth, whether because they are having an unusually low earnings year or because it simply makes sense to have those funds grow tax-free. Moving forward, there are no do-overs once that decision is made.

In Our Portfolios...

What's New With Us...

I will be ramping up my hiring search for a Chief Compliance Officer in the coming weeks. If you are curious to know more about the position or what I am looking for in a candidate, just ask.

Have a great weekend!

Brian E Betz, CFP®
Principal

Market Hits A New High As "Sell In May" Arrives

/ Percension Wealth Advisors, LLC/

In The News...

Interest rates held - The Federal Reserve did not increase its target lending rate (Federal Funds Rate), opting to keep it at 0.75% rather than increase it to 1.00%. Language coming out of the Fed's meeting last week was apparently enough to boost expectations that a rate increase will occur in June. The Fed likes to telegraph its moves, so I would be inclined to believe it. The most obvious impact these actions have are on short-term savings or loans, as those rates most closely mirror the Fed's actions.

Apple is cash king - For all the crap that Apple received in recent years for failing to innovate, we should admire their fiscal responsibility. Apple is notorious for hoarding cash, which has begged the question of what they would do with it. In the quarterly earnings call Apple announced a 10% dividend increase. The new, total dividend Apple will pay annually, $13.2 billion, is more than one-third of the companies in the S&P 500 are worth. Here is the full story.

Know your Social Security - A recent article in Time showed that fewer people are tapping Social Security retirement benefits when they first come available at age 62. The survey of 61-year-olds, done by Fidelity, found that 28% planned on taking early benefits, compared to 45% back in 2008. Of course the economy was on the cusp of recession back in 2008, but the decline is still encouraging. The closer you get to age 62 or your normal retirement age (which is 65, 66 or 67 depending on the year you were born), be aware of your options as they are nuanced. It is important to maximize your payout in retirement.

A lifeline for landline? A government study found that 46% of U.S. households have landline phones. I am not sure if this number is more or less than I would expect, but it's interesting. 50% of homes have cell phone service only.

In The Market...

The S&P 500 rose +0.7% last week. Let's look under the hood...

(data source: Yahoo Finance)

Stocks: Financials and Technology led the way, rising more than +1.0% apiece. Real Estate and Energy were again the lagging sectors. We own Real Estate (VNQ) in certain accounts, and while I do not like the short-term movement within the sector I remain bullish about the long-term view. The Real Estate fund we own also pays a 4.4% dividend, which helps soften the blow of a couple down weeks.

New high: The S&P 500 closed just shy of 2,400, marking an all-time high that eclipses the previous high set back in February. This matters for a couple reasons. First, all-time highs are bullish. Second, the S&P index does not account for dividends, which makes a new high look even better. This sets up pretty for well for the coming weeks, although the summer months do pose some risk (more on this in Opinion below).

Bonds: We did not learn much last week about the bond market. Most bond types were slightly negative, while preferred stock (we treat as a bond) did squeak out a small weekly gain. I still think Treasury bonds (TLT) will rally sometime soon. This would mean lower interest rates, as most predict rates to continue moving higher.

Here is why... Below is a chart of a widely owned long-term Treasury fund (TLT). This current point in time sure resembles late-2013 and late-2015, periods right before the bond market staged a massive rally. Take a look:

(chart created via stockcharts.com)

To be clear I don't think Treasuries are a "buy" just yet. But we are close. It doesn't seem right that bonds would take flight again after years of historically low rates. Popular opinion believes rates will continue to rise, not fall again. However, the data is what it is. History suggests long-term bonds may become very appetizing in the near future.

In Our Opinion...

May has arrived, bringing with it the popular question: Sell in May and go away?

This refers to the seasonal investing strategy of selling stocks this month, in anticipation that the market will tumble. While there is not a ton of statistical merit to support selling in the month of May, it really speaks to a broader seasonal trend that stocks perform much better in the fourth and first quarters, October thru March, than they do the second and third quarters, April thru September. (You will have to take my word on this -- I'll try digging up the specific stats in a future post. It is stark how superior Q4 and Q1 are compared to the rest of the year.)

So, should we care about "Sell in May"? No, not really. For one, the market remains strong on a long-term basis, as defined by looking ahead in weeks and months. Second, if we did see a sell-off I would still be looking for opportunities to invest, most likely in defensive stock sectors and bonds. Third, and most importantly, I do not think buying or selling based on a seasonal trend alone makes for much of an investment strategy.

Market volatility does tend to increase during the summer. Kids are out of school so families are on vacation, and thus, market activity slows. This gives sellers a bit of control. We will continue to evaluate market trends and adjust accordingly, as we always do.

In Our Portfolios...

Stocks: No changes last week. I really like the Industrials sector (XLI) right now, but do not feel it is worth selling any of our key stock positions to buy XLI just yet.

Bonds: No changes last week. I remain bullish preferred stock (PFF) and high-yield bonds (JNK), two of our current holdings.

Q&A / Financial Planning...

What do I need to do about my TD Ameritrade account?

A few of you have asked about next steps regarding TD Ameritrade. The answer is nothing. I will send you one more Docusign email that contains the transfer request, to move your account(s) from Scottrade to TD Ameritrade. Once that is complete I will provide log-in instructions for you to view your TDA account. I anticipate most accounts transferring over to TDA toward the end of this month.

For taxable accounts (namely non-IRA accounts), the cost-basis information will transfer over soon after your holdings do. This should result in receiving just one Form 1099 at year-end. Traditional IRA accounts do not need to worry about cost-basis information, as only withdrawals are taxed. Roth IRA accounts do not need to worry about either.

Let me know if you have questions.

What's New With Us?

I am mixing things up a bit. I am going to start sending these weekly recaps on Friday, as opposed to Monday. That way, for those of you who regularly read these, the market-sensitive information will be as real-time as possible. For those of you who occasionally read these but only as work/life accommodates, perhaps the weekend will present a bit more opportunity to do so. And for those of you who never click through to read these, well, you will not be reading this anyway... :)

I am always interested in your feedback -- what you like or dislike, topics you would like me to discuss more, the day of the week or time of the day you prefer getting these, etc.

Have a great weekend,

 

Brian E Betz, CFP®
Principal