Rates Rise; Who Cares?

These are heady times in the stock market. As market indexes set historical all-time highs, who cares about bonds? Stocks are all the buzz.

Back in August my letter was First Bonds, Now Stocks. “If you liked the bond market rally this year, then I think you will really enjoy the stock market rally which appears to be gathering steam.” Gather it has. The Dow Jones Industrial Average traded at 17,063 on June 27^th, 2016; on March 1^st, 2017 it was 21,169 for a 24% rise.

Meanwhile the bubble on Bonds did indeed burst as ten year Treasury yields bottomed at 1.32% on July 6, 2016, before doubling to 2.64% on December 15^th. So while stocks were gaining steam, bond prices were indeed weakening as yields doubled. As the Dow rallied, ten year Treasury bonds sank, producing an 11% price loss into the December yield highs. The long bellwether Treasury bond was down 22% in price over the same period.

Both the rise in stock prices and the fall in Bond prices were expected. After bond prices bottomed in December we expected prices to bounce and indeed the bounce appears to be over such that prices are trending lower again as the yield on the ten year treasury is back over 2.50%.

January’s Letter, Lines In the Sand noted Big Bill Gross’s line at 2.60% for the ten year treasury.  At just over 2.50% as March begins, we are within striking distance.

Shorter term rates, such as the Treasury two year note has also recently set new recovery highs in yield. The note yield bottomed in 2012 at less than .20%, where I marked the bond market’s historical low for yields. The note’s yield crossed 1% in December 2015 and 1.30% in December 2016.

The Federal Reserve, responding to the higher yields in the market, raised rates for the first time in nine years from .25% to .50% in December 2015 as two year note yields rose from .20% to over 1%. In December 2016, they raised rates from .50% to .75% as the yield hit 1.30%. As the note’s market yield continues higher it appears the Fed will once again follow with another rate hike, probably on March 15^th.

Whether the Fed raises interest rates in March is not important. If the market moves yields higher the Fed will eventually follow. Yields have risen over the past five years and the Fed has, so far, only moved twice.  Markets move; the Fed reacts, sometimes quite slowly.

Meanwhile as the trend for lower Bond prices is unfolding, stocks continue on their long-term trend higher. While this may be unusual over a longer period of time, it did not prevent me from writing about it last August.

The stock market is just that, a market. As such it is subject to actions that are best left unexplained. That the Dow is up 24% is a fact. Why it is up 24% is conjecture and in the realm of narrative. You should enjoy the ride, but also know the only way to profit (apart from the relatively the small dividends your stocks may pay) from this move is to sell.

Selling is hard. Long-term bonds, like stocks, need to be sold to lock in profits, especially if you believe a trend change in prices is at hand. Shorter-term bonds are in essence “sold” when they mature or are called. We usually evaluate our shorter-term bonds prospect for being “sold” when we purchase them. Because I believed the trend for the Bond market turned in 2012, buying longer-term bonds was not our goal as those bonds would ultimately be moving to lower prices.

Stocks, obviously, haven’t crossed their trend changing threshold. At Dow 21,000 they are indeed closer to the end than at last year’s lower prices. My thesis is this move is the end of something and the end of something big: thirty plus years of a bull market for stocks. We will see.

As a prudent investor, it may be worthwhile to begin harvesting (selling) stocks as the market continues higher. Perhaps by the time this letter is published stocks may be headed lower. Again, stocks are a market, so you should be ready for the unexpected because, over time, the unexpected happens.

As interest rates continue to move higher you should continue to benefit. Activity (sellers of bonds) has picked up over the past six months but I expect much more activity and hence ever better selection opportunities for municipal bonds in the months and years to come.