The economy may or may not be slowing, but it's clear that the stock market still loves the idea of lower interest rates.
Exhibit A is Wednesday's commentary from one Fed vice chairman. "Uncertainties about the economic outlook are unusually high right now," Don Kohn advised the Council on Foreign Relations on Wednesday, according to Reuters. "These uncertainties require flexible and pragmatic policy-making - nimble is the adjective I used a few weeks ago."
For the uninitiated, this may sound like casual chit chat on the rubber-chicken circuit. But for the savvy trader, this was insider code for: the Fed will CUT rates at the December 11 FOMC meeting. Fed funds futures have no reason to argue: as we write, the January contract is leaning closer to the idea that a 25-basis-point reduction is in the offing.
Perhaps at some point in the coming days another Fed head will take to the podium and give the stock market another reason to run equities up another 300 or so points on the Dow. This, dear readers, is the age of speculative opportunity in the stock market, albeit a wobbly one that's increasing dependent on obscure commentary by central bankers.
Fortunately, ours is a multi-asset class world that's accessible by ETFs and other publicly traded securities. For strategic-minded investors, there's always a varied mix of relative risk and return opportunities. U.S. stocks, for our money, don't look all that attractive, although they don't appear overly expensive either. This is not early 2000, when valuations were in the stratosphere. But neither is it 1982, when equity shares were about as popular as yellow fever.
For what it's worth, we expect U.S. stocks to tread water for the foreseeable future. Yes, on any given day there may be a pop (keep the Fed's speaking schedule handy, just in case). There's bound to be sharp tumbles too. All of which suggests to us that this is probably a time to keep U.S. equity weights average, if not slightly conservative. In fact, we're inclined to buy a bit on the dips and sell on surges, but only on the margins.
Meanwhile, we're keeping an eye on opportunities elsewhere. One quick example comes by way of high yield bonds. Comparing the historical yield spread for Citi US High Yield Index less the 10-year Treasury reveals that junk bonds are beginning to look attractive again, as our chart below shows.
The yield premium for junk is currently the highest in about four years. No, we're not suggesting it's time to pile in. The rising spread, after all, is a sign that the market expects higher default rates. Nonetheless, the asset class is starting to catch our attention once more. Sure, we're still cautious if only because history reminds that a risk premium of 5.4% pales next to the 10% posted back in 2002. Of course, waiting for 10% may be hopeless, unless you're expecting a deep and enduring U.S. recession.
We don't. Granted, we could be wrong. It wouldn't be the first time. But if the economy just slows, or even temporarily contracts, we think that default rates for U.S. companies issuing high yield bonds won't soar. And don't forget that the Fed seems inclined to pull out all the stops to keep a recession at bay.
Meanwhile, if you're considering rebalancing your portfolio by paring back on the big winners, there's the question of where to redeploy. Cash is always an option, although if more Fed cuts are coming, the payment for sitting on the sidelines will continue to diminish.
So, what about junk? Consider that the asset class has barely budged this year. Using the Vanguard High-Yield Corporate Mutual Fund as a proxy, junk bond total returns are 0.7% so far this year through Wednesday, according to Morningstar. In fact, it's quite possible that high yield debt this year is on track to post is lowest annual gain since 2002's rise of 1.7%.
Compare that with the soaring 35.5% year-to-date total return for emerging market stocks, as per the iShares MSCI Emerging Markets Index (NYSEARCA:EEM). No, we're not predicting that emerging market equities are set to crash and junk will soar. We don't know what's coming. But taking a little from the big winners and redeploying it to the relative laggards every now and then probably boosts a diversified portfolio's expected returns and lowers its expected risk.
The amount one redeploys depends on the depth of the apparent risk and reward potential in the given asset classes. By that standard, emerging markets look quite risky at this point while high yield bonds look, at most, only modestly attractive. That's hardly the greatest scenario for rebalancing, and so we'll still tread carefully. Fortunately, there are other asset classes to consider, although we'll stop here for the moment.
Of course, there's always speculating on what the Fed will do, and what the immediate reaction will be. Best of luck with that one.