Let’s begin this letter with the conclusion. I expect a correction from the recent January highs on the Standard & Poor’s 500. I believe it has already begun.
The media will blame it on the coronavirus, or something. It will last into late February and the index will likely decline 5%-7% from here. That will be a buying opportunity for stocks and a selling opportunity for bonds. Thereafter, stocks will recover into the summer, perhaps reaching new highs by July/August. Bond yields will back up toward 2% on the US Treasury ten-year at the same time. That will be time to sell some stocks and buy some bonds.
After that comes the election!
By the time November comes around, the election results will likely be discounted in the markets. The real issue is what happens in 2021. If inflation and interest rates are running a little hot, it will be a tough year for both bonds and stocks.
The correction is due because bond and stock market sentiment indicates extremely overbought markets. Last week, the S&P 500 was selling 15% above its 200 day moving average; very extended. Investors Intelligence reported 60% Bulls, an absolute danger zone. January is when new money is invested from retirement funds like 401-Ks. That happens in the first three weeks of the year. Stock and bond prices are up on the inflows. Those inflows have peaked.
Within the market, there are some interesting developments. The XLU, the ETF for utility stocks, has a relative strength index of 80, meaning it has outperformed 80% of the stocks in the broad market in the last twelve months. Strangely, the large capitalization Growth Index has a similar relative strength. So, the index with Apple, Alphabet, etc., has the same relative strength as the one with Detroit Edison. Wonder why?
Investors have been treating utility stocks like bonds. When the ten-year Treasury yield declines, utility stocks go up. The same is true for the large growth stocks, in spades. In fixed income speak, duration means how much prices change from a 1% change in interest rates. Growth stocks are the highest duration securities you can buy. A bit like 100 year, zero coupon bonds, growth stocks valuations change dramatically with changes in interest rates.
The XLU (utility index) has a dividend yield of 2.78%. Lots of good companies yield more. The QQQ (Nasdaq) has a dividend yield of 0.4%. Both will suffer if rates rise in 2021. The growth stocks had better grow their earnings and dividends, or there will be hell to pay!
A Note from WSC and WAMI . . .
Robert C. Davis is a Chartered Financial Analyst and is affiliated with Woodlands Asset Management, Inc. as a consultant. Founding partner of Davis Hamilton Jackson and Associates, a Houston based investment advisory firm; Bob is now retired and living in Chappell Hill, Texas. He now lends his expertise and knowledge of the markets to our company and customers. We hope you find it interesting and insightful.