Markets Look Less Weird, Thanks to Higher Rates

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This is very cheesy, but yield is destiny, and the yield on the market is back up at 2002 levels. It's way out of the range we've seen for the last 10-plus years. And the returns on bonds are going to end up delivering.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard, that's Robert Tipp. He's the chief investment strategist at PGIM Fixed Income, and he says yield is destiny. We're going to talk about yields and the relative attractiveness of the bond market now. We'll also say a few words about stocks. He mentions cheesy and delivering. I'm going to think about pizza. I don't think we'll have much to say about fast food. Oh boy. That's, that's the worst. That's the dumbest joke I've ever made in an intro, Meta. Come on. I blame you for letting me do that. Listening in is our audio producer Meta. Hi Meta. How are you? Hi Jack. I'm good.

I do apologize for doing that to you.

You can't let me do this to myself. You're here to stop me from saying things like that. We're going to be talking today broadly about financial markets. If you have an asset allocation that is skewed, that is not what it should be, we'll talk about getting back to a, a better one today. I think financial markets look mostly sensible right now, and that is a dramatic change from 2 years ago. I'm not sure that people quite remember just how weird things got a couple of years ago. It was bordering on financial nihilism. I will call this move back from then a reverse naked cowboyization of the market. And I'm referring to an episode that we did. Matter of fact, you were out on maternity leave. This was, um, it was right after Halloween in 2021, and we sent Jackson who was filling in for you to, um, there was an NFT conference in New York City. We sent them out to Times Square to speak with some people there. NFTs are non-fungible tokens. We've spoken about them in the past. It's, um, I don't know, they're supposed to be unique digital this or that, except maybe they're not super unique if they were going to change the world, only they didn't. It was a bunch of nonsense. Remember the ape faces? The ape faces were where people were paying fortunes for like cartoon faces of— is this making any sense? Are you— you aren't remembering any of this? I am. Yeah. Good. I regret buying 7 of those ape faces. That's not true. You did not do that.

I didn't do that.

No.

Good. Now Jackson went to Times Square and he spoke— there's a fellow— look, if you've been to New York City as a tourist and you've been to Times Square, you might have run into a fellow who calls himself the Naked Cowboy. A bit of false advertising. He is— he wears underpants and cowboy boots and a cowboy hat, and he carries a guitar, and he, you know, he plays some music, and he— I think he makes money by charging to have his picture taken with tourists. And anyhow, he had been hired for the day by some NFT folks. There was a— there was someone in kind of a worm getup, and they were representing an outfit that was selling holographic worm NFTs And so he was singing a song in support of that NFT.

Well, I'm the Naked Cowboy with the word NFT.

It's the cryptocurrency for you and me. And I think that that moment actually was peak weird finance. And by weird finance, I mean that interest rates had been kept so low for so long, in some cases with negative yields on government bonds in developed markets around the world that people just started buying nutty things, like really nutty. I know that there are still some people you could argue are paying too much for certain assets or maybe buying nutty things today, but it was off the rails a couple of years ago. At one point, the collective value of cryptocurrencies was greater than the money supply of the United Kingdom. And we're not just talking about Bitcoin here. We're talking about all manner of cryptocurrencies, including the parody ones, right? Like Dogecoin. There was one that was pretty hot for a while. I think the name was Australian Safe Shepherd, but no one spelled out the name. They used the acronym for it because it was fun for people to say the acronym for Australian Safe Shepherd. Anyhow, that coin ran up for a while. A lot of financing joke-based at the time. We talked earlier this year about a rebound for what's called the meme ETF. It holds meme stocks, but mostly it just holds broken momentum stocks. It's not quite the same as the meme stock activity we had a couple of years ago where a lot of it seemed to be based on irony, right? There was a run-up for a brief moment in a shell company that held assets of the former Blockbuster Video. There were multiple occasions of people running up the wrong Zoom stock, not the Zoom that does the video conferencing, but an unrelated Zoom that did something else. It was all nutty fun, or maybe not so much fun for people who lost money in these sorts of things, but a lot of that activity to me feels like it's been washed away by higher interest rates. This past week, of course, the Federal Reserve left its target Fed funds rate unchanged at a range of 5.25% to 5.5%. But if we go back just a couple of years ago, the range was 0% to a quarter percent. So that's a dramatic change. In other words, it used to cost you next to nothing to lock up money for a while in a bit of nonsense, unless of course that nonsense went down in value. But the cost of money was close to zero. Now the cost of money is you're missing out on the 5% plus that you could be getting in cash. And I think that's causing people to do fewer strange things and more normal things. I think it's a good time for people to take a fresh look at the deals available to ordinary savers in ordinary stocks and bonds. So let's do that now. I'll say a few words to start about the US stock market. Then we're going to hear from a global stock strategist and we'll end with bonds. B of A Securities put out a piece of research on the U.S. stock market this past week predicting 4% more upside for the S&P 500 index this year. Not bad, but the S&P already trades at 20 times this year's projected earnings. So how do you figure 4% more upside? For one thing, a lot of the priciness of the S&P 500 is clustered around those big tech giants that, that make up a large portion of the index. And BofA points out that businesses, they can do different things as conditions change. That's different from bonds where you get a fixed rate of return. For example, during the first quarter, Meta Platforms, the operator of Facebook and Instagram, it slashed costs and it returned a lot of cash to shareholders via stock buybacks. So more of those big tech companies could do that. They could shift from fast growth mode to cash generation and cash return to shareholders mode. And that might help to make the index a little less expensive. Companies could also become more efficient as they make greater use of artificial intelligence and automation. That has already been priced into some of the tech giants, but not so much the old economy companies, the smaller companies that you don't think of that much. And the standard S&P 500 index is weighted by company size. In other words, the biggest companies have the most sway, and the biggest companies are names like Apple and Microsoft and Amazon and Alphabet and Meta and Nvidia. And some of those companies are pretty ambitiously priced right now. There's also an equal-weight S&P 500 index where returns and valuation are not dominated by those big companies. The equal-weight S&P 500 index trades more or less at an average valuation compared with its history. BofA points out that the difference, the valuation gap between the biggest 7 stocks in the S&P 500 index and that S&P Equal Weight Index, it's the biggest difference in valuation since the tech bubble of 1999. It takes that to mean that the Equal Weight Index is priced to outperform. In fact, it predicts that the Equal Weight Index will outperform the standard S&P 500 Index by 5 percentage points per year over the next decade. That to me is an astonishing prediction. We will hear more about that and other things related to the stock market from Savita Subramanian, the top stock strategist at B of A, in the weeks ahead on this podcast. But for now, the point I take away from that is that the US stock market isn't that expensive, broadly speaking. It's just a cluster of stocks at the top that make it appear that way. Of course, the thing about the standard S&P 500 index is it's just been more right than everyone else this year. I wouldn't have predicted returns quite this high for stocks so far this year, and I certainly would not have predicted that they would be led by the same tech giants, the same growth companies that had led returns previously, but that's just what happened. And if you held an S&P 500 fund, you've gotten it exactly right. I take all this to mean don't sell out of your S&P 500 fund, but maybe add some stock exposure with things that are cheaper, an equal weight S&P 500 fund, maybe a small cap or mid cap fund. And that brings us to overseas stock markets. I spoke this past week with Gabriela Santos. She's a global market strategist at JPMorgan Asset Management. She feels that stock valuations in developed markets overseas are compelling relative to the US. The exposure is different overseas. There's less pure tech exposure and more of things like industrials, banks, commodities. Gabriella says there have been stretches in recent decades where that has not worked out especially well for investors, but the setup looks appealing now.

Yeah, and it all goes back to earnings growth. In the post-financial crisis up until the pandemic, really the earnings growth was found much more in tech and in the growth style, whereas really earnings growth lagged in your more cyclical or value style. But that wasn't always the case, right? If we look at the period from the post-dot-com up until the global financial crisis, it was actually the reverse. Earnings growth was much stronger in the value style and hence overseas than it was in the growth style and the US. So just worth considering that, you know, what holds for a certain amount of time is not always the reality if there's a catalyst for change. And this time around, if we think about some of the things that held back earnings growth in your more cyclical sectors, it was deflation in some of these markets. It was negative interest rates. It was fiscal austerity. And that's completely reversed this time around. We actually have inflation. We've had the end of negative interest rates, and we have fiscal spending and a huge amount of public and private CapEx happening. Which actually benefits companies like industrials and energy and materials.

Beyond the sector exposure, Gabriella says there has also been a change in corporate behavior overseas that bodes well for investor returns.

So if we think back over the past decade, a lot of the earnings per share growth that happened in the US was because of buybacks, and both Europe and Japan have discovered the secret sauce of buybacks as something that not just mechanically improves earnings per share, but also something that at the end of the day is rewarded by shareholders. So where we look today, the Eurozone has the same buyback yield as the US. Japan, starting from a lower base, but we're now hearing last year, this year of record buyback announcements.

Gabriella likes both the Eurozone and Japan, but says if she had to pick one, it would be Japan just because it's been, as she puts it, so forgotten gotten. There's a particularly large discount for shares there. Gabriella also says that after a 14-year strengthening cycle for the US dollar, that it's possible that US investors who put money to work overseas now could get some extra benefit from the dollar easing relative to the value of those overseas currencies. But she says that's a cherry on top, as she puts it, for the investment case. Mostly for her, it's about earnings growth and dividends and valuation expansion. For investors who want a cheap and easy way to buy shares in the Eurozone and Japan, there are index funds including ETFs. For example, iShares has funds for each. Their Japan fund, the ticker is EWJ, and their Eurozone fund, it's EZU. And that's a good place for a break. Coming up, we'll talk about bonds. Or as they call them in Denmark, obligations. Right, Meta? You almost nailed it. Back in a moment.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back. We're talking about bonds, and I'm looking at some historic Treasury yields here. I'm looking 2 years ago. If you had wanted to put money into a 10-year Treasury, you would have gotten a yield of 1.3%. And if you said, I don't want to lock my money up for that long, I want to stay as short as possible I want to buy a Treasury for a month. You would have gotten less than 1/10 of 1% in yield. Okay, so what about now? If you're buying that same 10-year Treasury now, you're getting 4.35%. And if you're staying short, if you're buying a 1-month Treasury, you're getting even more, over 5.5%. That's a pretty dramatic change., which should make bonds more attractive in general. We heard recently on this podcast from Kathy Jones, who's the top bond strategist over at Charles Schwab, and she said, yeah, it's time to buy. They think that yields are gonna move lower in the years ahead. Recently I spoke with Robert Tipp. He's the chief investment strategist at PGIM Fixed Income, and he says that most investors probably have too little weighting in bonds right now, in part because how stocks and bonds have behaved.

So investors are probably starting from a point of where they're at their norm in equities or higher than their norm in equities, and they're probably way above where you'd think they would be on a normal basis in cash, and they're below their strategic asset allocation in bonds. And if I just landed on Earth as an alien and I took a quick look, you know, at everything from Harry Markowitz to Bill Sharpe through where we are now, and you said, where should I be in asset allocation? I think you should get your strategic norm. Maybe the equities are a little bit high in valuation. The bonds look around fair value from a long, long-term historical perspective, but based on what we've seen the last 10, 15 years, they might be cheap. So those would be the directions that I'd be heading towards, is be a strategic normal allocation here, maybe above average in bonds and maybe below average in stocks.

A moment ago, I mentioned that you can get higher yields on short-term treasuries than you can on long-term ones. That's called an inverted yield curve, and it's the bond market's way of saying that it expects bond yields to broadly fall in the years ahead. But it raises the question of what investors should do. Should they stay short, scoop up higher yields, but run the risk that when it comes time to reinvest, they'll have to settle for lower yields? Or Should they settle for somewhat lower yields now and lock up money for 10 years or more on the assumption that those rates are gonna be better than what they're gonna see in the years ahead? Short or long? Robert says both. Just maybe try to stay away from the middle. He calls that a barbell approach.

You want a barbell on the yield curve. So if we're separating out our maturity decisions from our credit decisions, the most expensive part of the yield curve is between 2 and say 10 years. That's the part of the curve that is just highly confident in its pricing that the Fed is going to cut interest rates, say, 150 to 200 basis points. And I think the Fed thinks that they're not pre-committed to that. I know they have a really low long-term dot, but maybe if things balance out with an interest rate at 5.5 or 4.5 or 4, they will see a much more balanced expansion that's not reliant on excessive borrowing. That encourages some savings in the economy. So I think that we are generally near a peak in rates, but there's an opportunity in terms of how you position on the yield curve to avoid the parts that are lower yielding in the middle, to pick up average yield by barbelling, and to also avoid the rolling up the yield curve.

A roll-up or roll-down in the bond world refers to when the maturity of a bond changes. Let's say you buy a 10-year bond, you wait 5 years, now you've got a 5-year bond. And that matters because the yields are different at different maturities. And since we know the coupon payments on these bonds don't change, the prices have to change so that the yields adjust to what yields of similar maturities are going for. Now, all that really means here is with the short end of the yield curve paying more than intermediate bonds, If you buy one of these intermediate bonds and the price implies that the Fed is going to reverse course and it doesn't reverse course, then the yield on the bond itself is going to have to change as it ages to match the higher yields available on short-term stuff. In other words, the price of the bond might dip a little bit. How did I do, Matt? I know that was an awkward delivery, but it was a high degree of difficulty. What do you— What would you give me for my combined score? Much like a roll-up, I thought it was stretchy and fruity, flat but satisfying. You're thinking about Fruit Roll-Ups. Wait, what were you talking about? Bond roll-ups. I mean, same thing, really. So Robert's point, if you wanted to be more tactical, was stick with bonds that are 2 years or under or 10 years or over. But the broader point is it's probably time to buy bonds here if you're underweight in them, and many people are. And you could do that simply with just a broad market bond index fund, something like the Vanguard Total Bond Market ETF. The ticker there is BND. Earlier we heard Robert say yield is destiny, which totally gives me an idea for a full chest tattoo. Nobody needs to hear that. What he means is that with the stock market, if you're trying to figure out what your future returns are going to be, I mean, you can't say for sure, but the best you can do is look at your starting valuation and come up with some kind of calculation that tells you, okay, if you're starting from a place that's a little bit expensive, maybe your average 10-year returns going forward are going to be a little bit below average, that sort of thing. But with bonds, it's pretty simple. You look at your yield, and that's your best indication of what your future return is going to be. And right now, that's a pretty bright outlook.

You know, in all likelihood, over the next 5 to 10 years, for investment-grade bonds in mid-single digits, maybe a little higher if you have a little luck with rates coming down a little bit or some value added. And lower-quality fixed income will be higher risk but may very well end up delivering high single-digit, close to double-digit returns. Basically, probably competitive with what a lot of people might be expecting from their stocks. So, you know, I think bonds were fully valued if you go back 11 years ago. They stayed in that low yield range. They delivered that low return. We're in a totally different world here that looks much better for bonds, big picture.

Thank you, Robert, and thanks to Gabriella. And as always, thank you to the Naked Cowboy. We're going to be answering some listener questions in an episode coming up. So if you have a question, just tattoo it on your— now, you know what? Just tape it on your phone. Use the voice memo app and you can send it to jack.hough@barons.com. Thank you for listening. Metalootsoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, please write us a review. May cause drowsiness or itchy rashes. Use only as directed. See you next week.

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