Professional bond investors are canaries in the mine shaft when it comes to predicting long-term future movement in the economy. Unlike economists or pundits, bond traders are playing with real money. Long-term bets on the future of interest rates can move today’s bond values up or down significantly — prices drop if market interest rates rise and prices rise if market interest rates drop — like a rope over a pulley. Added to this is the fact that bond investments are purchased with borrowed money to a greater extent than stocks, and leverage, of course, can work both ways. Finally, the bond market is four times larger than the stock market in terms of the total dollars involved.
With all this money sloshing around and the risk that it entails, those playing in that sandbox tend to know what they are doing. If they seriously thought that President Trump’s predictions of 4 percent to 5 percent growth were a reality, they would not be buying long-term bonds that pay less than 3 percent. Instead, bond traders are setting an interest rate that reflects their expectation of about 2.5 percent growth. For their part now that the campaign is over, the administration is suggesting just 3 percent.
Meanwhile, the economy is in its ninth year of steady expansion — the second longest on record, so why do bond traders feel comfortable buying long-term bonds that will lock in low rates into the future? Because they sense that future growth will be anemic and that even these low rates will be a relatively good value compared with the alternatives. This usually is a signal of a recession or at least an economic slowdown. As short-term rates are rising, the difference between long- and short-term interest is now down to about half a percent, which is close to being a so-called “inverted yield curve.” This marks the point where loaning money for longer periods is considered to be less risky than to be stuck with soon-to-be-plummeting short-term rates in what is predicted to be a stagnant economy or recession.
Well, we’re not there yet, so things may work out fine. However, if things do not turn out well as a consequence of trade sanctions, wars and other negative influences, the stock market will probably struggle to retain its value. While the markets have been largely flat since January 1, a correction of 10 percent or more is overdue by any historical standards. However, in these situations, being out of the market and missing an uptick represents a far greater risk than being in the market during a downdraft.
That’s counter-intuitive until we look at the history of market performance. If, on a year-to-year basis, we take out the best-performing month of each year, the average annual return of the S&P 500 index was 2.7 percent from 1993 through March of 2018. Staying fully invested throughout the period brought the average annual return to 9.4 percent, according to a table provided by the American Association of Individual Investors.
What’s true about the best months of each year — especially when they happen to be unusually generous — is that they often follow some of the worst months. Human nature being what it is, many investors tend to sell after they have lost 10 percent to 15 percent in a falling market, which is termed “selling down to the sleeping point.”
But what happens next, inevitably, is a substantial rise in market values that these same folks then sleep right through. The average market advance from the day the last eight crashing markets hit bottom has been 37 percent in the following 12 months, with 20 percent of the 37 percent happening in the first eight weeks.
It’s all too easy to miss what then become the best months of the year, and the penalty for missing those gains can amount to two-thirds of what the average rate of return would otherwise have been. Living with periodic anxiety has its rewards.