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How to Handle the Markets' Mixed Messages

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Are the stock and bond markets sending mixed signals? I'm here with Matt Coffina, editor of Morningstar StockInvestor newsletter, to take a look at this topic.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start with the signals that the bond market is showing right now. What has that market looked like recently, and what do you think that means about what the bond market expects for the economy?

Coffina: I think going into 2014, a lot of people expected a steady rise in long-term interest rates. We ended 2013 at about 3% on the 10-year Treasury, and we've seen the exact opposite so far in 2014, where at this point the 10-year Treasury is yielding about 2.5%.

In other words, investors have changed their mind and decided that instead of gradually rising long-term interest rates, long-term interest rates have been falling, and keep in mind that long-term interest rates really reflect investors' expectations about future short-term rates.

So to the extent that long-term interest rates are down, that means that investors think that short-term rates maybe aren't going to start rising as quickly. They're not going to be as high three, four, and five years from now as they previously expected.

Glaser: What does that mean then?

Coffina: I hate to say it, but I think it's not good. It means that the bond market is telling us that interest rates are not going to be higher in the future, which presumably means that the economy is not going to be all that strong. You'd expect if the economy really started to pick up strength, inflation pressures would start to build and sooner rather than later the Federal Reserve would be in a position where it would have to start raising short-term interest rates.

I think the bond market is telling us that inflation still isn't a concern, and economic growth is going to be fairly weak for the foreseeable future.

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Glaser: But on the other hand, the stock market has done pretty well. What does that mean about what the stock market is expecting?

Coffina: The stock market’s giving us a completely different message. Maybe the market hasn't been up quite as robustly as it was throughout 2013, but we're still basically at an all-time high on the S&P 500 and other major indexes.

Small caps have pulled back a bit, but the larger-cap stocks certainly are giving the message that the economy is going to be very strong. And I think if that doesn't pan out, if it turns out that the economy is weaker and inflationary pressures are weak enough to justify keeping short-term rates at this very low level for a long time to come, it's going to be increasingly difficult to justify current stock prices.

Even over the last five or six years, most of the earnings growth that we've seen has come from higher margins. There has been very minimal revenue growth over the last five or six years, and I think that there's only so far that that can go in terms of margins increasing. At some point, you are going to need more robust revenue growth, which is going to mean more robust economic growth to support continued earnings growth and to support the kind of valuation levels we are currently seeing in the market. It's an open question as to who's right, the stock market or the bond market. But certainly I think the message right now is that the bond market is relatively pessimistic about the future of the economy and the stock market is still pretty optimistic.

Glaser: You said it’s open question of which one is right. Do you have a sense of how you would even think about answering that question? What are some of the factors that need to be considered?

Coffina: I honestly don’t know. I think the conventional wisdom is that the bond market tends to be a little smarter than the stock market. It tends to see things coming earlier than the stock market does. I think going into 2008 we saw more signs of concern in the bond market before stocks really saw their really severe sell-off. So that’s it; we don’t have an inverted yield curve or anything like that right now.

But I think the bond market’s message is at least cause for caution, and I wouldn’t say it's a reason to go out and sell all of your stocks. But I think it is a reason to tread carefully. If you do have cash sitting on the sidelines, maybe now is not the time to go all in on common stocks. If you have some stocks that you were thinking of selling anyway and they look like they are pretty richly valued, it might be OK to take some of that cash off the table and hope for better opportunities down the road.

That said, I don’t recommend in general holding a lot of cash for a prolonged period of time because the value of common stocks does tend to go up over time. When it comes to bonds, I’m still pretty nervous. I would say that there’s not a whole lot of upside and there is a fair bit of risk in current yields, especially on the longer end of the yield curve. 

But when it comes to common stocks, I think investors with a 10-, 15-, 20-year time horizon will do well enough even buying at the current prices. But I don’t think it's time to go all in, and especially I think we should be wary of the message that the bond market seems to be sending, which is that economic growth is going to be relatively weak and inflationary pressures are still nowhere to be seen.

Glaser: Sounds like there are some warning signs out there then.

Coffina: Definitely, at least yellow flags, if not red flags at this point.

Glaser: Well, Matt, thanks for your update today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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