Weekly Commentary Overview

  • Stocks continued to climb higher in the United States last week, despite sporting pricey valuations.
  • Three trends are helping to support equities: additional monetary stimulus from foreign central banks, a wave of mergers and low and stable interest rates.
  • However, with rates remaining low and investors continuing their reach for income, defensive, income-oriented stocks may be overvalued.
  • We would prefer to source our yield from other places, including U.S. high yield bonds and more cyclical sectors of the equity market.

Stocks Grind Higher

Stocks continued to climb higher in the United States last week, despite sporting pricey valuations. The Dow Jones Industrial Average climbed 1% to close the week at 17,810 and the S&P 500 rose 1.17% to 2,063, both setting new records. Meanwhile, the Nasdaq Composite Index was up 0.51% to 4,712. The bond market was little changed, with the yield on the 10-year Treasury essentially flat at 2.31%.

We would identify three trends that are helping to support equities: additional monetary stimulus from foreign central banks, a wave of mergers and low and stable interest rates. However, with rates remaining low and investors continuing their reach for income, defensive, income-oriented stocks may be overvalued.

A Confluence of Factors Providing Support

Equities have now rebounded more than 12% from their October low, in the process pushing valuations to their highest level since 2009. Nevertheless, stocks continue to benefit from several factors, including monetary stimulus, a fresh wave of mergers and acquisitions (M&A) and low and stable U.S. rates.

On the monetary front, the latest shot of adrenaline came from China. On Friday, the People's Bank of China cut interest rates for the first time in two years, igniting a global rally in stocks.

Equities also continue to benefit from a wave of M&A, with deals now totaling over $3 trillion for the year. Last week witnessed mega-mergers in both energy and pharmaceuticals: a $35 billion takeover of Baker Hughes by Halliburton and Actavis acquiring Botox maker Allergan for $66 billion.

The third factor supporting equities: low and stable bond yields. Despite the two best back-to-back quarters of economic growth since 2003, U.S. long-term yields refuse to budge. Declining inflation expectations are part of the reason yields are remaining so low. Five-year inflation expectations –– derived from the Treasury Inflation Protected Securities market –– recently hit 1.49%, the lowest level in four years.

This drop in inflation expectations has not gone unnoticed by the Federal Reserve (Fed). Recently released minutes from the last Fed meeting referenced this trend. For now, the Fed persists in its belief that inflation will "move back to the committee's 2% target over the medium term," a view supported by last week's release of slightly higher-than-expected producer and consumer inflation numbers.

In addition, U.S. bond yields are remaining low because yields in other developed countries are even lower. Europe's recovery remains weak and Japan has just slid into yet another recession. With German and Japanese bond yields well below 1%, a 2.35% yield on a 10-year U.S. Treasury seems attractive in comparison. This entices investors to buy Treasuries, supporting their prices and keeping yields low.

While the thirst for yield is understandable, it may be leading investors to overpay and take on hidden risks.

Yield Seekers Pushing Up Prices for REITs, Defensive Stocks

With bond yields both low and remarkably stable, investors in need of income continue to look for alternatives. One manifestation of this is a strong bid for so-called "defensive" equities, or stocks with low volatility and a high dividend yield. Real Estate Investment Trusts (REITs) are one example of this trend. The yield on the Dow Jones Select REIT Index was 3.3% at the end of October versus 2% for the S&P 500. This thirst for yield is one reason the REIT index is up about 20% year-to-date, roughly twice the return of the S&P 500. More evidence of the interest in REITs came last week with the largest-ever initial public offering (IPO) for a U.S. REIT, a $2.3 billion IPO of the Paramount Group.

But this quest for income is not limited to REITs. We see a similar appetite for defensive sectors of the stock market, notably utilities and consumer staples. While the thirst for yield is understandable, it may be leading investors to overpay and take on hidden risks. The defensive sectors all sport aggressive valuations and carry hidden duration, or interest rate sensitivity. If interest rates rise even modestly in 2015 — as we expect they will — these sectors are likely to perform poorly, as their valuations are particularly sensitive to rate rises. Instead of taking on more exposure to these parts of the market, we would prefer to source our yield from other places, including U.S. high yield bonds and more cyclical sectors of the equity market, which could be poised to benefit from an improving economy.

Where in the World Are the Equity Bargains?


What does an equity bargain look like? A market that has left investors extremely pessimistic, or a market that continues to perform? Perhaps both, according to Russ Koesterich.

Market Perspectives

Our experts take a deep dive in analyzing the outlook for key sectors of the financial markets across an array of asset classes.

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