What’s the deal with teenage boys and four-wheel drive trucks? Surely a future genetic study will identify a specific gene in many young men that indicates an insatiable desire to drive a jacked-up 4×4 into a big mud hole. My 17-year old son, Carlton, while seemingly on the right track with his academic pursuits, extra-curricular activities and general direction in life, somehow became obsessed with acquiring one of the aforementioned vehicles. He would say, “Come on Dad, I am seventeen years old. We live on a farm. I need a truck! I can buy an old junker and fix it up.” To be fair, Carlton has always had an interest in tinkering with anything with an engine, especially if it might go fast. You might recall an earlier Bragg Commentary that featured his rebuilding his uncle’s broken-down riding mower. According to Frank Bragg, Carlton is the only one of his fifteen grandchildren who has been “certified” to operate Frank’s 85-horsepower John Deere tractor, also known as “Big John.” Despite these interests, Carlton’s mother and I made it clear that he should put the 4×4 truck out of his mind and focus on more important things like his AP Chemistry homework. We told him that like his older brother before him, he would count himself fortunate to drive a practical, safe, high-mileage but well-maintained, previously-owned sedan. (Financial planning note for parents of teens: Car dealers are practically giving away used Accords and Camrys these days as everyone wants an SUV instead).
Carlton was not to be deterred. He spent hours and hours on Craigslist, 4×4.com and even military surplus sites searching for the perfect “rig.” I can’t count the number of times he interrupted my workday with a text that included a link to some Craigslist listing featuring a “lifted” Chevy truck with massive tires, a 10,000 lb. winch, brush guard, light bar and other so called “mods” (modifications). The price was always right and the comments were what you might expect: “1974 Chevy Blazer…274,000 miles…time to let my baby go. I got $5,000 in her…she runs good, hardly any rust, lotta tread left on tires…might need a little transmission work and a new muffler. Missing title. $2,100 OBO…will consider trade for fishing boat.” Reading the Craigslist entries was entertaining but I looked forward to the day when the sedan was purchased and this nonsense would finally end.
Things finally came to a head when school got out in May; we truly needed another car since Carlton and his sister each needed transportation to get to their summer jobs. So I set out one Saturday morning to find the perfect used sedan. I didn’t tell Carlton I was going. I planned to just bring home a sedan and put an end to this endless dreaming of going muddin’. I was encouraged when the very first dealership I visited had an assortment of used sedans that fit the bill. But as I walked through the lot, I couldn’t help but notice an old Toyota pick-up truck parked at the end of the row of sedans. You really couldn’t miss it; parked beside a Honda Accord, its lifted suspension and off-road tires made it stand out. I looked a little closer. It was ten years old and the odometer showed 105,000 miles. I saw that it was four-wheel drive, and yes, it had a manual transmission. It reminded me of the old 4×4 Toyota truck I drove in my youth. Man, I had loved that old truck. Standing there in the parking lot I felt a rush of emotion…nostalgia I guess.
I don’t need to tell you what happened next, do I? I’ll only say that I don’t know who was more shocked when I drove up in that truck—my wife, Alice or my son, Carlton. After hearing sermon after sermon about the merits of a practical, inexpensive sedan, they were simply dumbfounded by my purchase. Demonstrating how well he knows his father, my older son, Ben, described the event as “the strangest day in the history of our family.” I really can’t explain my behavior. Call it impulsive, emotional and irrational. It was certainly out of character.
Speaking of inexplicable behavior, market action of late could be described this way. As you are likely aware, the stock market, as measured by the S&P 500, ended the second quarter at an all-time high. The Dow made a new high on July 3rd. One might logically conclude that investors have lofty expectations for continued economic expansion and strong corporate earnings growth. After all, the stock market is forward looking. Meanwhile, bond investors are sending a different signal; yields on long-term bonds have fallen dramatically this year. The yield on a ten-year Treasury started the year at 2.7% and ended the second quarter at just 2%. As recently as last November, the ten-year yielded 3.2%. By historical measures, this is a dramatic reversal and the signaling is clear: bond investors expect economic activity to cool in the future. The fact that short-term rates are higher than long-term rates (the yield curve is inverted) points to a recession in our future.
So which market has it right? The stock market or the bond market? Is it off to the races as the stock market would imply or is an economic recession right around the corner as suggested by the drop in bond yields? I think I can explain this seeming contradiction more easily than I can explain my recent purchase of the Toyota 4×4. First, a refresher on bonds and interest rates. Recall that interest rates (yields) simply reflect the “price” of money or the price to borrow money. As with any other good or service, the supply/demand relationship is intact. When the economy is growing and good investment opportunities are abundant, the demand to borrow money increases, the supply of money becomes more limited, and this pushes up the price (interest rate) to borrow. Likewise when the economy is soft and investment opportunities are harder to find, the demand for borrowing declines and the cost to borrow (interest rate) falls. Today’s lower interest rates are telling us that bond investors expect a softening economy with fewer good investment opportunities.
So is the stock market being overly exuberant? I’ll make the case that it is not. The jump in stock prices we’ve enjoyed this year is simply an adjustment higher as a result of the lower level of interest rates. Recall that the price paid for a stock today represents the discounted present value of the future stream of earnings of the stock. A key component in the discounting of the future stream of earnings is the interest rate. The lower the interest rate used in discounting, the higher the present value of the stock. Stock prices, like the prices of all risk assets, have adjusted to lower interest rates. And while stocks, as measured by the S&P 500, are at an all-time high, they’re only 1% higher than they were nine months ago (September 2018) and only 6% higher than they were almost 18 months ago (January 2018). Corporate earnings peaked in the third quarter of 2018 and according to FactSet, expectations are for earnings to be flat to modestly higher in 2019 (see chart below).
The bottom line is that while earnings are treading water, stock prices have been driven up by lower interest rates. Notably, the current market rally began in late December after Federal Reserve Bank Chairman, Jerome Powell, in what will forever be known as “the Powell Pivot,” announced in a speech that the Fed would put future interest rate increases on hold. Just as my son seems to be addicted to 4×4 trucks, the stock market continues to be addicted to low interest rates. This has been the case for some time. It was six years ago when we dedicated an entire commentary to the market’s addiction to cheap money.
In summary, we think the bond market and stock market are sending consistent signals. The record-long expansion is showing its age and falling interest rates are propping up the stock market in the face of weak earnings growth. The S&P is up more than 18% through the first half of 2019. While good news on the trade front or other positive economic surprises could extend the rally, we think investors should temper expectations for the second half of the year.
As always, being comfortable with your portfolio allocation is most important. The allocation should reflect your need for liquidity and your comfort with market volatility. If a correction or bear market is in our future, either as a result of a recession or some other event, it will be important to be able to stay the course, four-wheel drive or not.
As always, thank you for trusting Bragg with your planning and investing.
2nd Quarter 2019: Market and Economy, by Matt DeVries, CFA