I thought you might like to see some interesting longer-term perspectives from Dorsey Wright and Associates (DWA) on interest rates and their connection to the equity markets in which we are fully participating. Earlier this week, the Federal Reserve raised the level for its target benchmark to 2.00%-2.25%. This is the third rate hike by the Fed this year. They also signaled rates will rise again in December. While rates are still historically low, it has been a long time since we have seen this level. There is a lot of discussion about how rates will affect the economy, but for most of you reading this, the real question is how rates will affect equities because they tend to lead the economy, and equities are most of what you currently own in your portfolios. By the time any recession has actually been identified in the past, equities have generally moved well before.
The first thing to remember is that, in spite of what you might read in the headlines, rising rates don’t automatically spell doom for the stock market. This fact often gets lost in the incessant search for attention-grabbing headlines by the financial media. Interest rates initially begin to rise because the economy is improving, and that is a good thing for equities. Eventually, rates go too high and it begins to choke off economic growth. This is part of the economic cycle. The interest rate level where equities are affected has actually been pretty well-defined historically. The chart below from JP Morgan Asset Management shows weekly S&P 500 returns versus 10-year Treasury yields. When rates are low, the S&P 500 goes up when rates go up. The tipping point is pretty clearly defined by the orange line at 5.0%. The 10-year Treasury yield is at 3.05% right now, so we have quite a ways to go until we get to that 5.0% level. The current tightening cycle isn’t automatically a bad thing for equities and should not be used as an excuse to stay out of the market at these levels. We assume that a 10-year Treasury rate of 5% is historically the level at which investors might determine the risks associated with the fixed income market are more favorable than the risks of staying in the equities markets.
The second part of the interest rate puzzle is the flattening yield curve. The yield curve measures the difference in interest rates between short and long-term issues. The chart below shows the difference between the 2-year Treasury and the 10-year. The darker shaded regions are recessions.
When the yield curve inverts, short-term rates are higher than long-term rates, and it is a sign of an impending recession. That is technically true, but the lead time between an inversion and a recession isn’t always the same. The conventional wisdom also says that a very flat yield curve is bad for equities. Looking at the chart above, that isn’t necessarily true. In the 1990’s, the yield curve stayed flat for quite a long time. There was a very shallow inversion in 1998, but the recession didn’t come until years later. Eventually, a recession will come. An inverted yield curve is an indicator of that, but it is difficult to determine what the lead time will be.
A very flat yield curve has actually been decent for momentum and relative strength over the years. We looked at each time the yield curve dropped below 35 basis points from a high level. When the yield curve gets really flat, momentum tends to do very well. Momentum tends to do very well at the end of the economic cycle as trends are already established and the leadership is in place. Looking out 12 months, momentum is a very good bet in these types of environments.
Interest rates have been rising, but that doesn’t necessarily mean impending doom for equities and momentum strategies. This has also been a time when stock market leaders have historically done better than laggards so we are constantly looking for portfolio laggards that may need to be sold and replaced with leaders. Looking back historically, we have a long way to go before rising rates turn from a positive to a negative for equities. Momentum, trend and relative strength are our guiding principles in technical charting. Regardless of the glaring media headlines and political theatrics in the news every day, we promise to do our best to stay true to these principles in all market conditions.
Please let me know if you have any questions or concerns or would like to schedule a meeting to discuss your personal financial situation.
