3 Things 9-14-26

 Thing One

A Couple Of Yield Questions For Your Consideration

Interest rates and bond yields are once again getting a lot of attention. The yield on the 10-year U.S. Treasury is now hovering around 5%, so I thought I'd address two questions that help explain why that matters.

Q: Why is the 10-year Treasury yield so significant?

A: The 10-year Treasury is one of the most important interest rates in the financial world because it serves as a benchmark for borrowing costs throughout the economy.

The 10-year is currently yielding roughly 5%. Movements in that rate influence mortgage rates, corporate borrowing costs and many other longer-term interest rates. For some perspective, the average 30-year fixed mortgage is currently around 6.8%.

But the 10-year also tells us something about what investors expect from the economy. When investors demand a higher yield to own long-term Treasury bonds, it can reflect expectations for stronger economic growth, higher inflation, higher Federal Reserve rates, greater government borrowing or simply greater uncertainty about lending money to the government for ten years.

That's an important distinction. A rising 10-year yield isn't automatically good or bad. The reason the yield is rising matters.

Q: What do rising yields mean for the stock market?

A: This is where things get interesting.

The S&P 500 is around 7,650 and is still up roughly 12% this year, even though Treasury yields have moved sharply higher. So higher interest rates do not automatically mean lower stock prices.

But they do change the math investors use to value stocks.

Think about it this way: if you can earn close to 5% lending your money to the U.S. government for 10 years, stocks have to compete with that. An investor who can earn around 5% without taking stock-market risk may be less willing to pay an extremely high price for a company's future earnings.

That's particularly important for companies whose valuations depend heavily on profits expected many years into the future. Higher interest rates reduce the present value of those future earnings, which can put pressure on expensive growth stocks.

Higher rates can also affect different parts of the market differently. Financial companies may benefit in certain higher-rate environments, and energy and other cyclical businesses can perform well when rates are rising alongside economic growth or inflation. Highly leveraged companies and businesses that depend on inexpensive financing can have a tougher time.

The takeaway is fairly simple: don't look at rising interest rates in isolation. Ask why they're rising. If yields are rising because economic growth and corporate earnings are stronger than expected, stocks can continue to perform well. If they're rising because inflation is accelerating, government borrowing is becoming more concerning or investors are demanding substantially more compensation for holding long-term debt, that's a different story.

And with the 10-year Treasury hovering near 5%, the bond market is giving stock investors something they haven't had to think seriously about for much of the past 15 years:  A legitimate alternative.

Thing Two  

Investing In High-Inflation Environments

Jason Zweig of the Wall Street Journal shared some insightful observations and advice with those of us concerned about the effects inflation will have on our investments.  In commenting on the accuracy of the experts (aka the Wall Street establishment) forecasts regarding inflation, he makes the following observations:

• “The more Wall Street agrees that a forecast is inevitable, the more likely the future is to repudiate it.”

• “Analysts, economists, and other forecasters are no better at predicting inflation than at predicting anything else: They stink at it. As then-chairman of the Federal Reserve Alan Greenspan noted in 1999, estimates of future inflation—including those by the Fed itself—“have been generally off,” and even changes in inflation that were “doggedly forecast” never occurred.”

(note:  in support of his observation that they stink at forecasting, Zweig points to a study done by Federal Reserve Bank of Philadelphia on the low level of accuracy in the last fifty years of inflation forecasting)

Regarding the salience of their advice relative to their forecasts he points out that:

• “…the assets often peddled as inflation panaceas don’t have magical powers.”

• “Gold, for instance, has sometimes failed to keep up with rises in the cost of living for decades on end. (It’s down almost 5% this year even as inflation worries have spread.)”

• “Nor are energy stocks or commodities a foolproof tool… Consumer prices rose in 1998, 2001, 2008, 2014, 2015, 2018, and 2020—and yet energy stocks and commodities lost money in all those years, according to Dimensional Fund Advisors, an investment firm in Austin, Texas.  In four of those years, both of those purported hedges lost more than 10%.”

So what does he suggest we do with our portfolios when inflation is looming?  The same thing that we should do in “normal” times – actually have a diversified portfolio of stocks that is, by design aiming to outpace inflation in terms of its total real return (capital gains plus dividends minus inflation).  I should note that for the highly risk-averse among us who are concerned only with the preservation of capital, TIPS (Treasury Inflation Protected Securities) are something he points out as a totally acceptable place to invest.  For the rest of us, it’s a range of equities (see the sector chart below).  In doing so, we should be prepared to accept short-term volatility on the way to long-term growth.

Thing Three

Just A Thought  

 “The key is not to prioritize what’s on your schedule, but to schedule your priorities.” - Stephen Covey