Stocks, bonds, and precious metals rallied during the third quarter with the S&P 500 up 5.25% and the Bloomberg US Barclay’s Aggregate Bond Index up 5.81% (YCharts). Stock market gains were broadly based across sectors and industries, in contrast to the first half of the year, when profits were narrowly concentrated among AI stocks and a handful of pharmaceutical companies involved in GLP-1 weight-loss drugs. Utilities, real estate, and industrials were the top-performing sectors, with each State Street Sector SPDR ETF posting double-digit returns through the quarter (State Street).
The bond market, and especially longer-maturity issues, also posted strong performances, buoyed by the expectation of lower interest rates over the next few years. Taken together, signs of a healthy stock and bond market suggest a high likelihood of positive returns through year-end.
The First Interest Rate Cut Since 2020
September 18 marked the end of the sharpest interest rate hiking cycle in over 40 years when members of the Federal Reserve’s Federal Open Market Committee (FOMC) voted to cut their benchmark interest rate by 0.50%. This policy pivot marks an important turning point for monetary policy – one which all but declares victory on the inflationary spiral that began in spring 2021. The cut was welcomed by investors, who see lower interest rates and lower borrowing costs as a net stimulus to economic growth.
Bond markets are already anticipating at least two more rate cuts in 2024 and another several in 2025. This has led the yield curve to “un-invert” and “re-steepen” for the first time since June 2022. That is, short-term interest rates were higher than long-term borrowing rates for the last two years, causing a “yield curve inversion.” This condition is unusual and reflects highly restrictive monetary policy. As of August 28, these conditions have reversed, and short-term borrowing rates are again below long-term rates. We call this whole process a yield curve “inversion” followed by a “re-steepening.”
Inversions & Re-Steepenings
Why does this matter? Many CNBC pundits are going to refer to this latest inversion and re-steepening as a leading sign of a recession. And based on history, a yield curve inversion and re-steepening has occurred before or during every recession going back to 1971. Below is an updated chart from our last quarterly commentary showing the difference between 2-year Treasury rates (short-term rates) and 10-year Treasury rates (long-term rates). When the difference, or “spread,” is below zero, an inversion is present.
Four Systems to Identify Negative Economic and Market Conditions
While we are paying attention to yield curve dynamics, you should never make a market forecast with just one indicator. To wit, we utilize four quantitative systems from multiple disciplines to come up with our outlooks and only make recession calls and de-risk portfolios on the rare occasion when all these systems are warning of weakness.
Let’s discuss each of our risk-on/risk-off systems. Our supply chain system seeks to identify positive and negative business environments. An example of a negative environment could be one where it’s costing more for businesses to manufacture products and the demand for those products is decreasing. This system is currently showing strong business conditions for both the manufacturing and services sectors.
Next comes our diffusion index of various labor, lending, interest rate, and liquidity indicators that historically lead to turns in economic growth and stock prices. One of the sub-indicators in our proprietary Leading Economic Index (LEI) is whether there’s a yield curve inversion and re-steepening. The fulfillment of this criterion currently weighs negatively on the index but is more than offset by healthy labor and stock markets, as well as minimal signs of stress in the lending markets.
Finally, there are two “money flow” systems that track demand for stocks. These systems primarily focus on small-cap companies, which are more economically sensitive and tend to lead larger, more well-established companies at major turning points. Both systems are currently reflecting strong, broad-based demand for stocks and risk assets. This is an indication of a healthy market.
Only in the very rare instance when all four systems are flagging weakness do we make a recession call. Currently, every system is indicating strength. This gives us high conviction that the bull market and economic expansion remain healthy and intact.
There Can Still Be Volatility During a Bull Market: The 2024 Election
Regardless of any longer-term economic and stock market outlooks, it’s a given that election day can bring with it short-term volatility. Historically, the S&P 500 has lost 0.23% the day after the election on average and gained 2.00% up through inauguration day. There is a wide dispersion around both averages, and returns seem to be closely linked to prevailing market conditions around the time of the election.
Let’s dig deeper. The worst stock market returns following an election were in 2008 when Barack Obama won. It would seem more likely that the nearly 20% market drop between election day and inauguration day was a product of the ongoing global financial crisis rather than the election. Similarly, the best post-election stock market return was after Joe Biden won the 2020 election. The market was surging following the COVID-19 recession, and new vaccines were beginning to be rolled out. This was probably driving the market more than the election results.
Fast forward to 2024, and economic and market conditions are robust, suggesting rising stocks through year-end regardless of who’s elected on November 5.
Bringing Everything Together: Bullish on 2024
We believe strong bullish tailwinds for both the stock market and the economy should bring global indices to new highs over the coming months. Normal short-term volatility should be expected, whether it be from the election, the ongoing Middle East conflict, or something else. What’s important for us is remaining focused on the long term and remaining dedicated to our evidence-based process for both analyzing markets and investing.
As always, my phone line is always open at (561) 972-8011 to discuss investments, financial planning, and anything else that we may be able to help you with.