The S&P 500 made a record high yesterday. It’s breached the 1,900 mark and is now up over 4% for the year, about halfway towards our forecast of high-single-digit returns for 2014. This move is notable given the economic and corporate earnings growth slowdown we saw in the 1st quarter. Obviously investors have given the economy and corporate profits a pass in the first quarter due to the severe winter weather the country experienced.
We need the economy and corporate profits to pick-up for this bull market to continue. I’m encouraged this will happen when I see stronger economic data-points emerge like the April “US Composite PMI”, a measure of manufacturing and services activity, hit a four-year high. The blue line in the chart below shows that U.S. private sector output is expanding at its highest rate in four years. Hopefully, U.S. GDP growth (green bars) will follow the strong PMI report.
The PMI report is good, but we need further confirmation that things are picking up from the slow 1st quarter. Right now:
- Stock market valuations are not cheap
- We’re in the “sell in May and go away” time period
- We haven’t had a 5-10% correction in some time
With this in mind, let’s be prudent in our stock market allocations and stick with quality, lower valuations and dividends (think G50). I don’t think we should sell stocks, but let’s be thoughtful with fresh money going into the stock market.
Interestingly enough the bond market is not cheap now either. The 10-year treasury yield has gone from approximately 3.0% to 2.5%. That means bond prices have rallied (interest rates down, bond prices up). Indeed, the aggregate bond market is also up close to 4% for the year.
With low yields investors may be inclined to chase higher yielding sectors of the fixed income markets such as high yield, emerging market, mortgage-backed or municipal bonds. But these types of bonds also look expensive. One way to measure the relative valuation of bond market sectors is with “credit spreads”. This is the yield spread between the 10-year treasury and the bond market sector you are valuing. For example:
· If the 10-year yields 2.5% and high yield bonds yield 4.5% then the “credit spread” is 2.00%
· When bond/credit spreads are lower they say spreads have narrowed and are relatively expensive versus Treasuries
· When bonds/credit spreads are higher they say spreads have widened and are relatively cheap versus Treasuries
The illustration below highlights how different bond spreads are historically narrow (meaning different sectors of the bond market are relatively expensive versus 10-year Treasuries):
The yellow dot illustrates the current yield spread for each bond sector and the green bar is the range of historic spreads the last 4 years.
So not only are 10-year Treasury yields low, but most sectors of the bond market have expensive relative valuations. It’s tough out there for fresh money being allocated to bonds in general.
We need to invest because we know that cash returns are next to nothing, but it’s tougher these days to find value in both the stock and bond markets. For now Gradient Investments believes that the G50 Portfolio is ideal for the current stock market environment, the Laddered Income Portfolio is ideal for the current bond market and the Absolute Yield Portfolio is ideal for investors seeking elements of both the stock and bond markets.
As of May, 27th, 2014:
Dow Jones US Moderately Conservative Index is up 3.61% (TR) for the year
S&P 500 closed at 1,911.91 up 4.31% for the year
U.S. 10 year Treasury Futures are yielding 2.50% down 0.47% for the year
WTI Crude Oil futures closed at $104.00 up $5.30 for the year
Gold closed at $1,265 per ounce up $61 for the year