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Stocks Drop as Interest Rates Rise

March 01, 2021
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Monday Morning QB - Market Observations:

  • Treasury Yields (Interest Rates) Shoot Higher
  • Fed Chairman Powell Reiterates His Support for Labor Markets…Vows to Maintain Ultra-low Interest Rate Policy
  • Commerce Department Reports 10% Jump in Household Income
  • Jobless Claims (New Applications for Unemployment Benefits) Hits Lowest Level Since November…Hiring Looks to Be on the Rise
  • House Passes $1.9 Trillion Stimulus Package

Monday Morning QB - Market Performance

The major U.S. benchmarks pulled back sharply in response to the quick and steep rise in Treasury yields (Interest Rates) last week. (Yields are the interest paid to bondholders.)

The Dow Jones Industrial Average shed 562 points finishing the week at 30,932, a decline of -1.8%. The NASDAQ Composite ended the week down -4.9%.

By market cap, the large cap S&P 500 declined -2.4%, while the mid cap S&P 400 and small cap Russell 2000 retreated -1.5% and 2.9%, respectively.

However, the three major indexes are looking to make a comeback after that bout of volatility last week. Retreating Treasury yields and vaccine optimism are giving a boost to markets to start the month. 

Rising Bond Yields & Rising Inflation Spark Economic Debate

The Case for Growth

The stock market has been the beneficiary of both the Federal Reserve's easy money policy and our government's historical fiscal stimulus. Both were needed to bridge the gap from shutdowns to a Vaccinated population.

The Commerce department reported on Friday that household incomes jumped 10% in January. This is the second-largest increase on record. The largest, of course, came last summer when the first government stimulus bill passed. Any guess how household incomes will react to the new round of stimulus?

Increasing household wealth has led to additional spending as well as savings. The increase in spending has given the business's bottom line a boost. The extra savings has made its way into the stock market, chasing the increases in corporate earnings.

Brokerage firms have announced record numbers of new accounts.

Why the sudden interest in stocks?

When bond yields are at an all-time low, they offer little to nothing for the investor. Thus, the increasing interest in stocks. Investors are pushed into more risky investment choices.

The allure of a rising stock market versus earning nothing in the bond market has created a new investor population. For instance, look at what is going on with GameStop and such. These are not necessarily the most financially educated new investor- but that is a whole other article.

So why the market jitters?

People have money, the vaccine rollout is improving daily, another vaccine is about to come online, and soon this nightmare will give way to a boom in pent-up demand for being around each other.

I have heard many travel stories. From exotic places, to just meeting people out for coffee or a beer and every point in between, people are ready to go. The economy will grow along with the go.

Demand will push prices higher, the very definition of inflation. But, inflation supplemented with economic growth is a good thing.

So, why is the stock market showing signs of the heebie-jeebies?

The Cases for Trouble Ahead

What if inflation rises faster than warranted by economic growth?

The typical tool to combat rising inflation is for the Federal Reserve Chairman to raise interest rates to slow down the economy – to take some money off the table. Less cash in circulation shrinks economic activity, creating lower profits for companies and likely lower stock prices.

For many investors last week, the inflation worry took over.

Some investors began to worry that the Federal Reserve will need to abandon their easy money policy sooner than expected and raise rates to counter the rising inflation. (See below.)

Another potential hit to the stock market will be the "risk off trade" dilemma. Higher risk is associated with greater probability of higher return and lower risk with a greater probability of smaller return. This is the opposite effect we have experienced for years.

Then, why take the risk of owning stocks when bond yields, the interest paid to bondholders, is increasingly higher?

Other investors may worry that should bond yields rise enough to entice people to leave the riskier stock investments for the safety of bonds, the stock market may decline.

This typically occurs when the stock market is at higher valuations, which many argue that it currently is. Technology, growth stocks, are showing the highest current valuations.

Money coming out of the stock market will create declining stock prices, but not necessarily a wholesale decline.

What is the Federal Reserve Chairman Saying About This Market Quandary?

Interestingly enough, the Federal Reserve Chairman was testifying in front of Congress for two days last week, during the whipsawing stock market reaction to higher bond yields.

Chairman Powell said the Fed doesn't foresee raising its benchmark Fed-funds rate from near zero until three conditions are met –

  1. A broad range of statistics indicate that the labor market is at maximum strength
  2. Inflation has hit its 2% target
  3. Forecasts show inflation to remain at the 2% target or higher going forward

Chairman Powell went on to elaborate where he believes we are currently, relative to his three-target scenario. 

In terms of inflation, he would not expect inflation to reach "troubling levels" and did not predict increases in inflation to be large or persistent. There goes that trouble ahead scenario.

He also gave an update on the labor market.

He stated that the Fed will maintain ultralow interest rates and continue big asset purchases until substantial further progress has been made toward its employment and inflation goals.

The Fed Has Its Doubters

Fed critics do not believe the Fed can meet their three goals without market instability.

They believe the economy will either overheat from a splurge in spending coming in the summer months, or the Fed policy will not create the economic growth the Fed is expecting.

Either scenario leads to financial instability, which likely leads the markets lower.

Corporate earnings should dictate the rise and fall of the stock market. We are wrapping up a home run earnings season with companies raising forward guidance.

In the absence of earnings reports, investors look for other signals to gain an advantage over fellow investors. Much of the news outside of earnings season is simply noise.

As for the Federal Reserve's ability to "slow land" their ultralow interest rate policy and their bond-buying strategy, only time will tell. Who knows, maybe making easy money in the stock market is coming to an end?

Our indicators are flashing conflicting signals, with the Discipline flag showing caution and the market strength indicator still in positive territory where it has been since last April.

We will continue to follow our risk management discipline.

As always, we are here for you! Don't hesitate to call with any questions or concerns you may have.

Have a great week!

(sources: all index return data from Yahoo Finance; Reuters, Barron's, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, zerohedge.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, www.stocksandnews.com, www.chaikinanalytics.com Chaikin Analytics, www.marketwatch.com, www.BBC.com, www.361capital.com, www.pensionpartners.com, www.cnbc.com, www.FactSet.com, W E Sherman & Co, LLC)
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