• Wealth Management

When Stocks Sound Too Optimistic, Listen to the Bond Market

As stocks and bonds diverge in terms of the signals they send about the direction of the U.S. economy, here’s why you should pay attention to bonds.

The performance of U.S. stock and bond markets has been impressive this year. The S&P 500 is up 18%, near its all-time high. The U.S. Barclay’s Aggregate Bond Index is up 6% so far this year.

As pleasing as it is for diversified investors to enjoy gains from both asset classes, it’s probably unsustainable. Typically, bond yields rise (and the price falls) as stock prices gain, or vice versa. My research shows that the six-month U.S. Treasury yield and stock returns have moved in the same direction 80% of the time for the past 20 years.

This year’s correlation reflects the very different economic outcomes priced in U.S. stock and bond markets. Bonds are pricing in a recession and several Federal Reserve interest-rate cuts; stock prices suggest a temporary economic slowing, quick resolution to trade disputes and a return to a healthy level of inflation.

Which is right? The current economic backdrop, fraught with trade tensions and complicated by a dramatic Fed policy pivot early this year, is murky, but I’m currently paying more attention to the signals coming from the bond market.

I think investors should scale back on their exposure to the S&P 500 Index and emphasize high-quality, value-priced stocks. Below are three reasons why risks seem stacked against the U.S. equity market:

  • Macroeconomic backdrop: Economic data continue to deteriorate, even as the stock market shrugs it off. Lately we’ve seen weakness in autos, housing and manufacturing. Durable goods orders fell again in May, after a terrible April reading, and consumer readings suggest cracks in confidence, a bad sign for the economic outlook.
  • Earnings outlook: While first-quarter corporate earnings avoided disappointing investors, mainly due to inventory-building and slashed expectations, second-quarter results may not fare as well. Consensus analyst estimates measured by FactSet are forecasting a year-over-year profit dip of 2.6%, while Morgan Stanley Chief Investment Officer Mike Wilson forecasts a 5%-6% second-quarter earnings decline.
  • Market variables: The S&P 500 may reflect investors’ broad-market optimism, but key market subsectors appear less sanguine. The underperformance of segments that usually perform well when the economy is strong, such as small-capitalization stocks as well as banks, transportation and other cyclicals, is worth noting. Also a potential red flag for the growth outlook: The recent price surge in gold—often considered the ultimate defensive investment—to six-year highs.

Stocks may well trade higher over the next few weeks, lifted by the truce between the U.S. and China coming out of the G-20 summit and hopes for a permanent treaty that resolves crucial differences, as well as a potential Fed rate cut in July. But the gathering evidence points to a U.S. recession ahead. The higher stocks trade, the deeper they fall if the stock market eventually comes around to the bond market’s view.

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