Fed Funds 5.25% - 5.5%, US Ten Year 3.901%, Oil $73.55
Dow Jones Industrial
Standard & Poor’s 500
Investors have enjoyed a robust stock market beginning in November after the August through October doldrums. The rally has extended into December and appears that it will continue into the new year, powered by “dovish” Fed comments from last week’s FOMC meeting. We saw the ten-year bond decline from 5.1% in late October to its current 3.901%, quite a rapid fall in rates.
Expectations of lower Fed Funds rates in 2024 continue to fuel stocks. The November report on inflation was better than expected, with CPI up just 3.1%. This was helped by a fall in the price of gasoline and fuel oil. The environment looks good for continued lowering of rates.
Chart: CNBC. Data: Bureau of Labor Statistics.
Are investors a bit too confident about the timing and/or extent of rate cuts? In my December 8 Weekly Market Update I described how stocks valuations are reasonable and bode well for continued strength next year. I based the conclusion on next year’s earnings projections, historic and forward-looking price-earnings ratios, continued strong consumer spending, and expectations of lower interest rates given the benign inflation just reported. But there are always risks, from weakened consumer demand, renewed supply change shortages, and stubbornly high interest rates. While the FOMC’s “dot plots” indicate three 25 basis point drops in Fed Funds next year, futures contracts are pricing in six reductions. Six reductions may be unrealistic and stock investors too confident. It is interesting to note that the interest rate curve remains inverted, increasingly so with the recent fall in ten-year rates. Inverted yield-curves are historically a sign of bear markets.
It is important to note that a bear market does not cause a recession but is a consequence of a recession. There are signs that the long-predicted recession may occur next year, such as the decline in the Conference Board’s Leading Economic Index which has fallen 3.5% over the past six months. Aside from historical correlations, there are other reasons why an inverted yield curve may forecast recessions. It can suggest the Fed is raising rates above normal levels and that can often cause a recession. Also, an inverted yield curve can create a more challenging environment for banks and other financial intermediaries, which can lead to reduced lending, contributing to a potential recession. If we do enter a recession next year, remember that recessions last an average of 17 months. It would not be wise to make drastic changes to a stock portfolio to try to “time the market,” which is nigh impossible to do. Instead maintain broad diversification in equity portfolio, balancing high growth, low yielding stocks with recession-resistant stable dividend payers. Consider a “barbell” approach in fixed income portfolios, balancing short-term rates with longer ones such as ten-years bonds, to lock in higher long-term rates should a recession occur.
Have a Wonderful Week