What's Going On? Stock Markets, Bond Markets And The Economy

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Includes: DIA, IVV, SPY
by: John M. Mason

Summary

The stock market is down and bond prices are up and the economy seems to be going nowhere.

The economy is growing only at a modest pace and inflationary expectations have fallen considerably this year. The stock market is off its peak and bond yields are extremely low.

The uncertainty in the world is huge right now and the economy and the markets are reflecting this uncertainty.

The S&P 500 stock index has dropped off more than 5.0 percent from its historic close on September 18 to close at 1906 on Friday, October 10.

The Dow-Jones Industrial Average has dropped off by about 4.0 percent from its historic close on September 19 to close at 16,544 on Friday, October 10.

On October 9, the yield on the 10-year Treasury fell to 2.29 percent, down from a close of 3.04 percent December 31, 2013.

The price of gold dropped below $1,200 on October 3 to the lowest price since early August 2010.

The price of oil has fallen to $85.56 on Friday, down from a close of $107.30 per barrel on June 20 of this year.

The growth rate of the economy in the second quarter of 2014 was 2.8 percent, year-over-year, not particularly great… but still growing.

The growth rate of industrial production in the third quarter will come in at around a 4.4 percent, year-over-year rate of increase, again not great but still growing.

The inflationary expectations built into the bond market are now below 2.00 percent when they were around 2.25 percent at the end of last year.

And, market financial market volatility has picked up. The swings up and down this week have been huge!

What's going on? The answer is…it's hard to know.

In terms of the economy, the recovery we are now in is the third longest economic recovery since World War II. The question is still in the air… how much longer can this expansion continue?

Analysts have been looking for "green shoots" since the spring of 2010… and they continue to jump on every little positive piece of information being released. People continue to look for the economy to "take off"…but, nothing much ever seems to come from all these little pieces of "good news."

Hanging over this performance is the condition of Europe… on the verge of a third recession in the past six years. China's growth seems to be falling. And, the same appears to be the case in Brazil and Argentina.

Many analysts attribute the decline in the price of oil to the expected slowdown in world economic growth.

One thing I believe has surprised everyone is the drop in inflationary expectations. With all the liquidity in the economy, pumped in by an exceedingly generous Federal Reserve System, the inflation hawks have been called for a renewed inflationary environment for the past five years.

Yet, the inflationary expectations in the United States have dropped pretty dramatically over the past few months. In recent days five-year inflationary expectations were around 1.80 percent - ten-year inflationary expectations were around 1.95 percent.

It appears as if the environment of disinflation… or outright deflation… has kept the price of gold under control or even caused it to decline to a near term low. The market, within the current environment, does not seem to be too buoyant.

This, of course, is one reason why the yields on longer-term government bonds have declined to such low levels when almost everyone at the end of last year was predicting these rates would rise.

In Europe, longer-term inflationary expectations have dropped pretty dramatically. And we see that the yield on the 10-year German bund is around 0.90 percent. With real price deflation seemingly on the horizon for Europe, investors seem to be thinking that the recession there is going to produce some results not seen in Europe… of America… in a long, long time. One has to look at Japan for some recent experience with price declines.

And the stock market, analysts that look at the CAPE measure of stock market value created by the economist Bob Shiller, including myself, have argued for some time now that the stock market is overvalued. As Shiller has recently commented, the market is overvalued but the over valuation is not so extreme that one can reach a strong conclusion that the market will decline in the near future. The CAPE measure does not give us an indication about timing… so, we can say the stock market is overvalued, but this does not necessarily gives the signal of when to start selling.

One of the things that, seemingly, has been keeping the stock market at such high levels has been the behavior of the Federal Reserve System. At the Fed, under its policy of quantitative easing, has pumped enormous amounts of funds into the banking system. Given the argument that one should not "fight the Fed," many have argued, myself included, that the high level of stock prices has been a result of Fed ease.

But, the quantitative easing will end this month. What the Fed will do in upcoming months, whether or not the Fed will oversee a rise in short-term interest rates, are all surrounded by a great deal of uncertainty right now. Expectations seem to change just about every week on when the Fed will act… how the Fed will act… and how the financial markets will react to these Fed actions. How can you not "fight the Fed" if you don't know where the Fed is going?

Which gets us to another point. Talking about the government. The Federal Government… and especially the White House… are perhaps creating the greatest amount of uncertainty in the economy right now. First off, there are a lot of other issues on the minds of those in the White House… ISIS, Russia, Ebola, and so on... and these areas along with who knows what will dominate the attention for some time.

Second, the White House seems to be focusing solely on the upcoming mid-term elections and anything it does with respect to the economy seems to be focused more on the election results than anything else. For example, the recent action on "tax inversions" was solely done to create an election-day issue to energize the political base. Although some companies may be impacted by it, the measure is close to being ineffective. But, the White House will drop the issue as soon as the election is over… or as soon as the White House determines it is having no impact on the election.

Third, the President is already a lame duck. His ability to get anything done with respect to economics in Washington seemed to have ended some time ago. Even if the Democrats maintain control of the Senate, not much will be done in the next two years relative to economics.

This uncertainty about the economic future, which has been around now for awhile, has increased over the course of 2014. Adding to that the real fear of a world recession, a "boots-on-the-ground" battle in the Middle East, and a confrontation with Russia has just exacerbated the uncertainty in the world and has resulted in much more volatility in the financial markets.

Things are not going real well in the world and policymakers are not in a position to do much about it… or, maybe don't know what to do about it. To me, this is a picture of the current state of the world. People… investors… just don't know which way to go.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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