One of the peculiarities of this rate-cutting cycle—recall that the Federal Reserve slashed interest rates by 50 basis points in September—is that it comes at a time of full employment and robust economic growth, which sounds more like an environment suitable for rate hikes, not cuts. The unemployment rate in September was just 4.1%, and the economy expanded by an impressive 2.8% in the third quarter, according to the government’s initial estimate.
What’s good for personal incomes and economic growth isn’t necessarily ideal for stocks—particularly since the market typically looks out six to nine months in discounting the future. Raymond James conducted a historical study of subsequent market performance after the economy reaches full employment (which it defines as 4.2% unemployment, which is essentially where we’ve been the past several months). They found that, historically, the market has returned an average of only 4.3% annualized over subsequent 5-year periods, compared to a long-term average market return of 10% to 11%.
Raymond James adds that we’re also starting from elevated valuations: At recent prices, the valuation of the S&P 500 Index, as measured by P/E ratios based on 12 months’ forward earnings estimates, was higher than during 92% of past periods over the last quarter century (and 95% of times for the S&P 500 Growth Index). Peak multiples on near-peak profit margins at full employment do not sound like a particularly attractive recipe for equities. As David Kostin, chief US equity strategist for Goldman Sachs Research, wrote recently, “In theory, a high starting price, all else equal, implies a lower forward return.”
The market link with employment makes intuitive sense. Full employment (a characteristic of a late-cycle economy) generally places upward pressure on labor costs, especially for skilled workers, which can trigger inflation in goods and services. In addition, during the last three years, foreign-born workers accounted for a large majority of growth in the labor force. After this fall’s elections, while a continuing influx of immigrants is somewhat in doubt, we can count on a continuing surge in baby-boomers entering retirement (on average, approximately 11,000 Americans turn 65 each day).
In fact, there are signs that market participants think the Fed’s 50-basis point cut was too dovish amid a strong and resilient economic backdrop. Since the cut in mid-September, the yield on benchmark 10-year Treasuries has climbed 60 basis points, inflation expectations have ticked up and the bond market has reduced the number of rate cuts it anticipates this cycle. Moreover, bond investors at home and abroad also seem to be growing more concerned about how (and at what price) the Treasury will continue to fund our mammoth budget deficits—5% to 7% of GDP each year over the next decade, according to Congressional Budget Office projections—on top of $28 trillion of debt held by the public, equal to 99% of GDP. LPL Research notes that, in recent years, a 4.3% yield on 10-year paper (which is at 4.26% as we write) has marked a resistance level for stocks.
There are enough indications that we may be late enough in the cycle that investors should be considering some risk management strategies and diversification in their portfolios—particularly for investors who neglected to rebalance allocations during the market’s rise or who are nervous about the present environment.
Considering full employment, high stock valuations, a bleak fiscal outlook, and some skepticism about how much the Fed can afford to lower interest rates, it seems sensible to consider taking some equity chips off the table. One strategy to “play it both ways” is to move some of those chips into a long-short fund, which can provide considerable downside risk management in stocks while participating in rising markets.