Our monetary composite was downgraded to its worst possible rating (M6) this week on the inversion of the yield curve (4 Week Moving Average of ratio between the 10 Yr Note and 90 day T-Bill going below 1). This does not alter our recommended weighting toward equities, as we continue to recommend maximum exposure to stocks. This is in large part due to phenomenally good stock valuations as well as market psychology signals this summer that have indicated excessive investor pessimism is everywhere. Even last week, the ratio of NYSE volume to NASDAQ volume reached levels that have historically been associated with excessive pessimism from investors.
We believe that inflation expectations peaked in May on the Fed funds rate increase to 5%. Gold and other metals peaked then, and the bond market’s inflation expectations peaked in May as well, as measured by the difference between the 10 Yr Treasury and the 10 Yr inflation protected treasuries. With fed funds at 5%, the TIPS yield continued to climb even in the face of decelerating inflation expectations. It was after the increase to 5.25%, that TIPs yields peaked, which we believe illustrates that this was the level that began to hurt growth along with inflation.
Let’s look at this from another angle. According to economist Jim Smith, over the last couple hundred years, bond yields have averaged 300bps above expected inflation. Using this statistic with Bernanke’s often quoted preferred range of 1-2% for inflation, you should have long term expectations of a range between 4-5% on the 10 Yr Note. So, a 5.25% fed funds rate is constrictive based on this view as well.
We are not economists, meaning you can file both of our examples under the realm of guessimates. What we do know is that the yield curve has not yet been inverted long enough or to a significant enough a degree to indicate a recession is on the horizon. As we have tried to hammer home several times, monetary conditions follow investor psychology, albeit with a lag. We have to be patient and give the significantly improved wall of worry time to work its way into Fed policy. In the meantime, keep on your rose colored glasses, and look for good news. Bonds are oversold, and stocks are extremely cheap and wound up like a coiled spring. Very favorable seasonality is just around the corner as well.
I agree wholeheartedly that valuations, especially for large cap stocks, are attractive. However, I'm not sure that I buy the argument that investors should ignore the negative monetary trends. The world's central banks are universally restrictive, and this factor, more than any other, has caused the swoon in stocks since mid May. A positive first step will be a pause in interest rate increases from the Fed. If that occurs, I'll be more willing to put on my rose colored glasses. But until the Fed becomes less restrictive, I believe cheap stocks could get cheaper.