4th Quarter Outlook – Beware of the Bond Vigilantes

It has been my intention since we started this “newsletter” to inform you on what we expect to happen – not what already happened.  Roughly speaking, to tell you what you may not know.  And to make it as brief as possible.  A few sentences, a few charts, and be done in less than 10 minutes.  Fair?

First, let’s start with the hot topic – Inflation.  It’s the above title – Bond Vigilantes.  This is a term that was first brought out in the 1980’s when politicians wanted to keep raising the National Debt.  To pay for the debt, the Treasury would issue more bonds to pay for it – but the buyers didn’t “have to” buy the bonds.  And if they did, they wanted higher rates.  Fast forward to 2023, and the same thing is happening today.  As I write this, the 10-year bond rate is 4.78%.  A week ago, it was around 4.25%.  Higher bond rates mean higher interest on the debt – which means more bonds at even higher rates, etc., etc.  So, the marketplace is telling the politicians to lower the debt (which needs to be in place by Mid November) or we will “make you” (recession or credit crunch).  Could get interesting.  As a little side note, much of the government spending is obviously political – help the poor, middle-class, rich-poor gap, etc.  Note that much of the Government bonds are purchased by the rich.  They get the interest on the bonds.  And then taxes are needed to pay for the debt.  And who pays? Everybody!  But it hurts the Middle Class the most.  If you can’t see the irony here… The bigger problem is that we increased our debt enormously in good times.  The country is spending when they should be saving.  What happens when the next crisis happens?

Don’t despair too much as there is another side of the coin.  Inflation is coming down – probably faster than you knew.  See the chart below.  First, you have to understand that housing makes up around 27% of inflation.  And that part (along with wages) has been the most “sticky” as it’s a lagging indicator.  So, look at Figure 45.  See how low inflation (CPI and PCED) is without rent!















You should also know that if you take out housing out of CPI, it’s at around 2.5% – almost the Fed long-term rate.  Now look at figure 43.













The Fed looks at PCE:  housing services – and that will soon (already started) roll over and fall just like Zillow!  This almost guarantees that inflation will continue to fall.  We should see Core CPI at 3.5% by year-end, and 2.5% by the 3rd or 4th quarter next year.  Oh, and for those of you who say – “what about energy and food?”  You make an excellent point.  But if one looks at the futures market (where the “big boys” play), oil prices for May of 2024 are at approximately $81 per barrel – about $10 lower than today.  Still expensive but not going up.

Second, let’s talk about valuation.  First, the “headline” P/E for the S&P 500 is 17.8%.  But if you take out the 10 largest companies, the P/E falls to around 16.5, below the 25-year average of 16.8.  So, we are fairly valued on the surface.  But there are some serious under valuations.  Look at Figure 16 – P/Es for Large, Mid and Small Stocks.  The Mid Cap is 13.2 and Small Cap is 12.3 – both well below their long-term averages.  And then look at the First Trust chart comparing Pure Growth to Pure Value.  Value looks cheap!









































But what about future growth?  The S&P 500 will come in a bit under $225 p/s this year, but project it to be $250 next year and $275 in 2025.  To show next year’s growth by quarter for all stock sizes, look at the “squiggle” on Figure 10.  Quarter by Quarter it gets better.

























That leaves us with … What to do?  First, we have stated that interest rates will eventually fall due to lower predicted CPI numbers.  So, the typical 60/40 portfolio, the 40% will have the wind at its back for the next 3 – 4 years.  On the 60% side, I don’t want to sound boring, but diversification is the mantra.  I already made my point on small and mid-cap plus value.  Plus, international is priced cheap (more to follow).  Earnings are coming in good and should stay that way (fingers crossed).  Speaking of International, see the chart below.  Notice that it is so oversold that it’s close to the second standard deviation.  Crazy oversold.  Yes, China has been going through some pain, but India and Japan are doing very well.  Make sure you have some in your portfolio.
















Finally, I will leave you with a fun piece.  It’s a table showing gains and losses in the S&P 500 over the past 94 years.  There’s a couple of things I wanted to point out.  Note that the market is up 20% or more than 36 times, or 38% of the time!  And losses for only 27.4% of the time (losses more than 10% for only 13.8% of the time).  So roughly speaking, over the past 94 years, the market is down less than 30% of the time, up between 0 to 20% about 1/3 of the time, and over 20% well over 1/3 of the time.  Just a little perspective.
















For this year, we may have already seen our high – but think we should get close to it again by year-end (4600 on S&P 500).  It’s early but 2024 looks a little better than average.  10 – 12% to start with a chance of recession 20-25%.  Most likely we are going through a “rolling recession” right now – first manufacturing, now commercial real estate, etc.  No real bubbles to pop.  Mergers and acquisitions should pick up next year along with stock buybacks.  Plus, election year.  Reminds me of the old Hunter S. Thompson saying, “When the going gets weird, the weird turn pro!”


If you would like to schedule a time to discuss the market and/or your account(s), please do so here:  https://calendly.com/brian-hpou or contact me anytime at 832.200.3440 or via email at brian@publicsafetyfg.com.

Past performance is not a guarantee of future results. Indices mentioned are unmanaged and cannot be invested into directly. Diversification and asset allocation strategies do not assure profit or protect against loss.  These are the opinions of Brian Craft and not necessarily those of Cambridge. The views expressed herein are for informational/educational purposes only and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal.

Author Brian Craft, AIF

Published October 9, 2023