Catching a Falling Knife

A lot of people have been asking me lately why the stock market has taken a downward turn. I must admit, I can come up with a lot of answers to the question: The economy is having to contend with the removal of an unprecedented amount of fiscal and monetary support; we have a dysfunctional government that can’t even agree on leadership within its own ranks; federal government debt has spiraled out of control and the U.S. credit rating could be cut again soon; banks are tightening lending standards in response to rising credit losses, deposit flight and higher capital requirements; the housing market is frozen for lack of supply, and commercial real estate is suffering a major downturn; geopolitical uncertainty abounds as the Ukraine War continues and a new war begins in Gaza; and the Chinese economy, which had been the engine of global growth for so long, is undergoing a major deceleration. I could go on. In fact, perhaps a better question might be how were stocks able to hold up so well in the face of these formidable headwinds. 

But perhaps the best explanation for why stocks are falling is much simpler. After all, the domestic economy has defied all expectations and held up quite well in the face of all the aforementioned factors. The Atlanta Fed’s GDPNow forecast is currently calling for GDP growth of 5.4% in the third quarter on top of the 2.1%-2.2% pace in the first half of this year. Earnings for the companies in the S&P 500 are expected to rise 7%-8% this year and another 10%-11% next year. Inflation has dropped all the way from 9.1% in mid-2022 to 3.7% in September of this year (Consumer Price Index). The Fed appears to be done raising rates.

So what is causing the stock sellers to come out in force? The answer is probably that the stocks now have formidable competition. Rather than enduring the short-term volatility and uncertain returns associated with stocks, investors can now earn 5% or more with no credit risk by owning U.S. Treasury bonds. The chart below shows that not only do Treasuries offer much higher interest rates than the stock market’s dividend yield, but Treasury yields are now approaching the stock market’s earnings yield as well! The earnings yield is simply the inverse of the P/E ratio, and it represents another way to track how much investors are willing to pay for a dollar in corporate earnings. At the moment, the earnings yield for the S&P 500 is 5.7%, or the inverse of the current P/E ratio of 17.5x. The difference between that 5.7% earnings yield and the yield on the 10-year Treasury bond is now just 0.76% – by far the lowest in the past 10 years. The interpretation of this is that investors are not getting compensated nearly as much for the added volatility assumed by owning stocks. 

How much should we read into this analysis? Probably not too much. After all, interest rates could fall just as quickly as they rose if the economy shows signs of faltering. Still, it is interesting to me that there hasn’t been greater substitution of stocks for bonds than we have seen. After all, investors haven’t been able to get “risk-free” returns like this for many years. Could this mean that interest rates are headed higher still? I guess it’s possible. At some point, though, it will become clear that the economy can’t withstand interest rates this high for an extended period following many years of near-zero borrowing costs. When that happens, those brave enough to “catch the falling knife” that is the current bond market will start to look pretty smart. 

Warren Buffett likes to say, and I paraphrase, that people love to buy hamburgers when they are half price, but they run from stocks and bonds when they have dropped in value. Well, this year is shaping up to be the third straight losing year for the most widely followed bond index, the Bloomberg Aggregate. Prior to last year, that index had never been down for even two consecutive years since its inception in 1975. On the equity side, we are also starting to find some really good value in defensive, blue-chip stocks that are not among the seven largest technology companies responsible for the vast majority of the S&P 500’s year-to-date return. Investment opportunities, which had been so rare for so long, are beginning to materialize.