You could rightly say that this has been an “interesting” year for investors.
On the surface, you’d probably think the broader market would be struggling. There are concerns about an escalating trade war with China, the yield curve has inverted for the first time since 2007, and just last week, the Institute for Supply Management’s manufacturing index fell to 49.1, signaling a contraction in manufacturing activity for the first time in three years.
Yet the broad-based S&P 500 is having an incredibly strong year, with a year-to-date gain of 18.8% through this past weekend. Despite the at-times sensationalist headlines, the S&P 500 ended the week a mere 47 points away from hitting an all-time closing high.
The oddball reason the stock market should hit a new high
Although much of the talk of late has been about the yield curve inversion and the likelihood of a recession over the next 12 to 18 months – every recession over the past 50 years has been preceded by a yield-curve inversion, though not every yield-curve inversion guarantees there will be a recession – I’m having different thoughts. I believe the stock market is in prime position to thrive, if not soar to new highs, and it has an odd reason to thank for its catalyst: fear.
First off, you have to understand that the stock market and the U.S. economy aren’t tied at the hip. What’s good for the economy isn’t always good for stocks, and vice versa.
For example, on numerous occasions over the past year, we’ve witnessed the market sell off on news of stronger-than-expected jobs growth. The reason is that investors want the Federal Reserve to continue lowering the federal funds rate, which it’s less likely to do if economic growth, including jobs growth, remains robust. So there has been this bifurcation between economic news and stock market performance for some time now.
This bifurcation is important to note, because it demonstrates that consumer and investor fear isn’t necessarily a precursor to a poor-performing market.
The bond market will play a key role in pushing investors back into stocks
It’s the bond market, however, where fear will exert its greatest influence and help to push stocks to new heights.
With Wall Street clearly worried about trade war escalation between the two largest countries in the world by gross domestic product (GDP), investors have been opting to buy U.S. Treasury bonds as a safe-haven investment. The thing is, bond prices and bond yields have an inverse relationship, meaning that as more investor money flows into bonds, yields decline. Recently, the 10-year and 30-year Treasury notes hit respective three-year and all-time lows of below 1.5% and 2%.
Now, here’s where things get interesting. Although U.S. bond yields are still light-years higher than the $17 trillion and counting in global government debt that’s now sporting a negative yield (ahem, Japan and most of Europe), most U.S. bonds are generating negative realized yields once you factor in the inflation rate of 1.8% over the trailing 12-month period. Essentially, investors aren’t making any real money by diving into bonds as a safe-haven investment.
In my opinion, this is likely to cause a knee-jerk effect that shifts investments back out of bonds and into safe-haven stocks. By “safe-haven stocks,” I’m talking about low-volatility, generally moderate- to high-yielding time-tested businesses. Right now, there are few means of generating inflation-topping income beyond equities, which makes stocks a logical choice, by default, to benefit.
There’s a pattern here: Fear induces a minor market sell-off, investors flock to bonds, and yields plummet. Then, investors scurry back to stocks, sending them to new highs. This could occur in a rinse-and-repeat pattern for some time.
We’re already seeing evidence of this effect in action
Believe it or not, I’d contend that we’re already seeing evidence of fear driving safe-haven stocks and the broader market higher. Remember, most safe-haven stocks have established business models and are large-cap or mega-cap stocks, thereby giving them a lot of influence over the S&P 500.
One perfect example would be telecom and streaming-content giant AT&T. As a shareholder in AT&T, I can attest that its operating results have been OK, but nothing special in 2019, with wireless strength being offset by cord-cutting. Yet the year-to-date return for AT&T is nearly 29%, not including dividend income, through this past weekend. Among mega-cap stocks, few if any can beat AT&T’s 5.7% dividend yield, which is more than triple the inflation rate in the United States. With substantially lower volatility than the S&P 500 and guaranteed income – AT&T is a Dividend Aristocrat that has raised its payout for 35 consecutive years – it has been a prime beneficiary of plunging bond yields.
Another beneficiary of market fear has been beverage giant Coca-Cola. After its stock did virtually nothing from 2013 to 2018 other than pay out a reasonably strong dividend, shares of Coca-Cola are up by almost 17% in 2019, not including dividends paid. Coca-Cola has benefited from exceptionally strong organic sales growth, driven mostly by improved consumer demand, but is most coveted by investors for its branding power and income potential. Coca-Cola’s 2.9% yield is more than a full percentage point higher than the trailing 12-month inflation rate, and its beta of 0.31 shows that its stock is only about 31% as volatile as the S&P 500. It’s a perfect safe-haven income stock.
Then there’s consumer products company Procter & Gamble, which has tacked on just shy of 34% this year, not including dividends. Like Coca-Cola, this gain came after Procter & Gamble’s stock was virtually flat from 2013 to 2018. However, plunging global bond yields have created quite the demand for large-scale, brand-name businesses that pay a hearty dividend. Procter & Gamble’s yield of 2.4% may be lower than Coca-Cola’s or AT&T’s, but it has increased its payout for an impressive 63 straight years.
The idea might sound ridiculous, but fear could very well lead the stock market to new highs.