In our Market Commentary from November 11, we talked about a stock rotation that had been underway since early July out of industry sectors offering high dividend yields and into sectors with better growth prospects. This rotation, we said, was due to several factors: 1) improving economic data; 2) the passage of the Brexit vote without major market disruptions; 3) campaign rhetoric promising stimulative tax cuts and infrastructure investments; and 4) a change in Fed posture in favor of policy normalization (interest rate increases). The beginning of this rotation also coincided quite nicely with a bottoming in the 10-year Treasury yield at 1.36% on July 8th. Since that time, the yield on the 10-year Treasury has risen over 100 basis points, giving yield-oriented investors a decent alternative to higher-yielding stocks.
Thus far in 2017, this rotation continues. Investors continue to shun higher-yielding industry sectors in favor of those better poised to benefit from accelerated economic growth. In the scatter plot below, you can see the undeniable negative correlation between sector dividend yield and sector performance for the year-to-date period. Obviously, a healthy amount of optimism continues to be priced into the stock market.
But unlike in late 2016 when nearly all indicators were flashing green, there are now conflicting tea leaves that should be given due consideration. The bond market, which many believe is a better predictor of future economic conditions, has been seeing substantial buying activity in the new year. In fact, after topping out at 2.60% on December 15, the yield on the 10-year Treasury has dropped back down to 2.38% today. Investors often buy US Treasury bonds when they are concerned about future growth (among other reasons). Are investors simply taking advantage of the rapid rise in interest rates, or does the bond market know something that the stock market is not seeing?
Perhaps more ominous has been the rebound in the price of gold. Since bottoming in late December, the gold price has increased almost 9% to a 3-month high. What is driving this renewed love for the yellow metal? With the help of Investopedia.com, here are some of the most commonly cited reasons for buying gold:
- Gold tends to benefit during periods of market volatility;
- Gold can be a safe haven during periods of policy (fiscal or monetary) uncertainty;
- Gold can also be used to protect wealth in periods of geopolitical uncertainty;
- Gold can be used as a hedge against inflation, which can basically be defined as periods when paper currencies lose value;
- Since it is generally traded in dollars, gold can serve as a hedge against dollar weakness (and indeed the dollar has been pulling back in 2017 following sharp increases in the second half of 2016);
- Gold can also serve as a hedge against a deflationary environment (like during the Great Depression);
- Following a period of decreased mining (in reaction to falling gold prices), some investors may be betting on a shortage in gold supply;
- Since gold isn’t highly correlated to other asset prices, it can be used to diversify one’s portfolio
The conclusion? Though the evidence is by no means definitive, some markets seem to be telling us that investors had been a bit hasty in expecting a dramatic acceleration in economic growth as a result of the new president’s economic policies. The bull scenario could certainly still unfold, but it seems like now, at the very least, investors are baking in a more realistic time frame with regard to the implementation of new policies. If this is indeed the case, the rotation into high-octane, cyclical stocks could be a bit overdone at this point.
Farr, Miller & Washington is constantly studying financial statements, valuations and news developments. Our job is to understand, as fully as possible, what we own and why. We always look to the poor performers hoping to find new opportunities. But we also evaluate holdings that have performed well as there may be opportunities to reduce exposure if price has well exceeded fundamental support. You can expect more of the same as we navigate these increasingly uncertain waters.