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Posted by on Feb 23, 2018 in Crossing Wall Street, Featured, Market Insight

Crossing Wall Street Review – February 23, 2018

Crossing Wall Street Review – February 23, 2018

By Eddy Elfenbein, editor of Crossing Wall Street and portfolio manager of the AdvisorShares Focused Equity ETF (Ticker: CWS)

“I made my first investment at age eleven. I was wasting my life up until then.”
– Warren Buffett

John Maynard Keynes famously described the irrational behavior of financial markets as being the result of “animal spirits.” Given the market’s behavior during much of 2017, the animals in question must have been snails, wombats, turtles and sloths.

That all changed a few weeks ago, when the stock market had one of its sharpest corrections in decades. Since then, things seem to have gotten back to normal. I’m not so sure.

The S&P 500 is still below its 50-day moving average, and I think there’s a good chance we’ll soon see more dips.

How the Market Is Stuck in the Middle with You

Unlike previous market breaks, the recent one was more serious. Not solely because it was steeper and sharper, but because there are more fundamental concerns driving it. Brexit or the election or hurricanes can pass quickly, but rising yields are a more pressing threat. I don’t mean to say that the market is ready to take a plunge, but I want to stress that I believe the investing climate will become more challenging this year.

Let’s start with the basics. Interest rates are going up. This week, the one-year Treasury broke 2% for the first time in nearly a decade. The 20-year bond recently broke 3%, and the 10-year won’t be far behind. The yield curve is also starting to flatten out at the long end. This means that yields level off after about seven years. Not completely, but it’s a big change from where we’ve been.

One metric I like to follow is the spread between the 20- and 30-year Treasuries. In June 2016, the spread was 46 basis points. Lately, it’s been as low as 11. What I’m describing is happening at the long end of the curve, but it may soon spread to the short end. Currently, the difference between the three-month Treasury yield and the two-year yield is greater than the difference between the five-year and 30-year.

If this sounds like mumbo-jumbo, I’ll boil it down. Rates are going up, and that puts the squeeze on stock valuations. This week, the Fed released the minutes from its last meeting, and the members appear quite confident that rates need to go higher.

The CME futures market currently sees an 83% chance of a Fed hike next month. There’s a 66% chance of another rate hike in June, and a 65% chance of a third hike in December. (There’s also a distant bet of four hikes by December. Yikes!)

The odd thing about the higher yields is that they’re due to a good thing, which is the improving economy. The unemployment rate is still low. This has been a very good earnings season for Wall Street. The “beat rate” is the highest since 2006. Economists expect more good numbers for Q1. Americans’ expectations for the economy are the second-highest since 2002.

What’s happening is that two counteracting forces are at play. The strong economy is boosting profits. In response, the rising economy is lifting interest rates. Stock valuations tend to move in a contrary direction to interest rates. In other words, the P/E Ratio is going lower, while the “E” part of the equation is getting bigger. This means the “P” part, the prices, is kinda stuck in the middle.

The information, statements, views, and opinions included in this publication are based on sources (both internal and external sources) considered to be reliable, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. Such information, statements, views and opinions are expressed as of the date of publication, are subject to change without further notice and do not constitute a solicitation for the purchase or sale of any investment referenced in the publication.