Since November 9, the stock market has rallied about 5%. I am comfortable with this rally and I am cautiously optimistic that it can continue. First, as we have discussed all year, the stock market often moves higher after a Presidential election because the anticipation is over. Even though our election result may have been surprising to many, investors reacted with a sigh that one source of uncertainty had passed. Since President-elect Trump has very different priorities than may have been anticipated, the market rally started even stronger as fast-money traders quickly moved out of some sectors and rotated into others they speculated would benefit from new policy priorities. Such rotation continues and is still nothing more than speculation.
More importantly, the election coincided with the end of third quarter corporate earnings reports and a decisive end to the mid-cycle slowdown. Even more than the election, the current stock market rally reflects optimism in future earnings growth and economic potential given the status quo. Keep in mind that the stock market is currently making a new high only after more than 24 months retreating from its previous peak. Even still, the strength is not across the board as the averages suggest; formerly weak sectors such as materials and industrials are rallying and reliably strong sectors such as consumer goods and technology are retreating, even offering buying opportunities.
Finally, our Federal Reserve just raised interest rates and definitively signaled that more increases are likely in the coming few years due to economic strength. Though, the market initially sold off on the announcement, a rising Fed Funds rate sparked by stronger economic growth is usually supportive of the stock market and signals optimism in the future. I think we may have down days or even weeks, but can expect the stock market to move higher for a while, barring surprises from our new leadership next year.
The Bond Market
In contrast, I expect the fixed income portion of investors’ portfolios to require strategic attention in 2017. Bond valuations start with straight-forward math that relates bond maturities to prevailing interest rates. In simpler terms, as interest rates go up, bond prices go down. Interest rates are likely to continue to go up, so we will be focusing on strategies to protect capital and also benefit from rising income potential.
First, we are exiting all bond funds for anything other than temporary cash. Funds own a broad mix of bonds that will all go down in price as interest rates rise. Next, we are currently focusing on using cash to purchase short -maturity bonds, bonds with variable interest rates and step-rate callable bonds. Unlike, the future “potential” from purchasing a stock, the return on a bond is locked-in the moment it is purchased. Purchasing short-term bonds provides capital protection with modest income return. However, since rates are rising, as each short-term bond matures, there is the opportunity to buy a new bond with a higher interest rate.
Variable rate bonds are also very attractive as interest rates rise. These bonds do not have a fixed interest rate; they vary with each payment based on prevailing interest rates or inflation. The interest paid is usually a formula with a fixed component and an added “hedge” for moving rates. Since the rate is always changing, the prices of these bonds tend to stay more stable even as rates rise.
Finally, we also are using bonds that have a schedule of rising rates built in. These are known as “step-rate” bonds. They have an initial interest rate for several years that is consistent with the current market. But then the interest rate rises in future years. If rates do not rise as much as the bond offers, the issuer usually “calls” these for early pre-payment. If rates do rise, the bond provides added protection by already offering a higher interest rate in the future.
These are just a few of the strategies we are already using and will continue to employ to provide capital protection to portfolios. As Joe Weisenthal at Bloomberg points out, we are in a new era post the financial crisis. The Federal Reserve has declared victory with its latest move in interest rates and the constrained policy responses of the past eight years are likely to change with new leadership in our government. We do not know how this era will unfold. It may bring positive economic growth, a new recession or the next financial crisis. For now, we invest for the economic potential we see going into 2017.