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Where Are Rates (and Stocks) Headed in This Part of the Business Cycle?

By Mike Patton

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In last week’s blog, we began a discussion on the stages of the business cycle and how economic data reacts. This week, we’ll look at a few general investment themes to consider at this stage of the cycle.

As mentioned, stocks tend to do well when corporate profits are strong. However, because investors will invest on the ‘expectation’ that profits will rise, since the goal is to get in early, stocks often tend to overact in either direction, up or down. Moreover, if you are early and are wrong, in other words, profits don’t rise as expected but actually fall, then the magnitude may be amplified. This is one example of a risk event when investing in stocks and why some consider the stock market to be a leading economic indicator. Now that earnings season is underway the results thus far have been mixed. Also, many expect GDP in the second quarter to be as low as 0.50% and will certainly fall below 1.0%, which is a real concern to Ben Bernanke. You see, the Fed is very troubled with the prospect of deflation and will do anything it can to avert it. Hence, I would not expect a tapering of QE anytime soon. Given the prospect that the money train will remain on its current track, what might transpire in the near term? How might interest rates react? 

In the second quarter, interest rates rose sharply over a very short period before stabilizing. If interest rates resume their ascent, bonds will begin to look more attractive on a relative basis as their price declines and their yields surpass that of dividend-paying stocks. However, I wouldn’t count on interest rates picking up where they left off quite yet. In fact, it is my belief that they will either remain close to current levels or decline slightly with mortgage rates following suit. Also, the Fed has emphatically stated that it plans to hold the discount rate where it is for the foreseeable future. It’s the movement of the five-year plus part of the yield curve that’s a mystery. 

Actually, if mid- to long-term rates do rise, the yield curve would steepen, which would create an even more favorable environment for banks. Of course, it’s impossible to know for sure. At this point, it’s just one working theory. Turning to the general economy, how will it perform in the short term?

The Economy and Stocks

Our economy has been in slow-growth mode for quite some time. Actually, the notion that the second half of the year will produce GDP in excess of 3.0% plays like a rerun of Gilligan’s Island. Where did they get all that stuff anyway? Is it possible? Sure. Is it likely? Not so sure. 

Therefore, unless productivity improves, which would boost corporate profits, and until top-line revenue growth accelerates (i.e., demand rises appreciably), profitability will not be as strong as we might like. This doesn’t necessarily equate to flat or declining stocks. In fact, it’s entirely possible that under this slow-growth scenario stocks will continue to rise. One important factor would be the relative attractiveness of U.S. stocks to other asset classes. In this case stocks could certainly continue to rise. However, the longer we continue down this present path, the more worried I become about a stock bubble and crash at some point. This is because we cannot continue to pump massive amounts of liquidity into the system without incurring some sort of negative consequences down the road. 

Where are the areas of potential reward for investors? I would consider floating rate funds, heathcare funds and bank funds. I would also consider large U.S. stock index ETFs, buying on the dips, and placing a relatively narrow trailing stop order underneath to minimize losses. 

Finally, it may be wise to maintain some dry powder in the event we do see a correction. Oh, if we could only see the future! Maybe the foresight goggles are back in stock? Maybe not! 

Thanks for reading and have a great week!