Investor’s column: Here are the two ends of the tug of war pulling at the stock market

It’s been a volatile time for stocks of late.

One day last week, the market was down 500 points, then briefly in positive territory before closing down over 120 points.

What’s going on here?

There are two ends to this tug of war. One is the robust economic growth of our economy and the other is increasing interest rates and what that will do to the economy and the stock market.

Let’s start on the rosy side with our outstanding economic growth. Much of the data supporting this view is from Brian Wesbury, chief economist with First Trust. Mr. Sunshine as he is often called.

He is expecting real GDP (gross domestic product) for the third quarter to expand at an annual rate of 3.6 percent. According to Wesbury, it is clear that cutting taxes and slashing red tape have boosted growth.

There is room to run and he doesn’t see recession coming for at least the next two years. Here’s how we get that growth.

Real personal consumption grew at an annual rate of 3.1 percent. That will add 2.1 points to the real GDP. Business investment grew at a 6 percent rate, which will add 0.8 points as well.

Home building will decline at 2.6 percent annually that will subtract 0.1 points. Government purchases soared recently to 2.1 percent annually that will add 0.2 points. Trade inventories will subtract 1.8 points while inventory accumulation should add 2.4 points.

Add those figures together and we get a 3.6 percent annualized growth. An outstanding figure compared to the previous eight years of only about 2.1 percent.

Now for the other side of the tug of war. A lot of this supporting data comes from Russ Koesterich, CFA with Blackrock. At this end, while earnings are great, stocks need easy credit. While relatively supportive now, at the margins less so. P/E’s (price earnings multiple) are contracting. Whether they rise again, unlikely according to Koesterich, stay the same or fall will be determined by credit markets.

The conditions are not as supportive as they have been because of an increase in the dollar that has risen almost 9 percent since the February low as well as an increase in both long-term and short-term interest rates. The two- and 10-year Treasury yields are up 100 basis points and 85 basis points each. One hundred basis points equals one percent.

Higher interest rates and a higher dollar create a tightening of market conditions. Tighter financial conditions historically lead to an increase in volatility.

Until recently, volatility had risen but was well below its long-term average. This can be attributed to the fact that credit markets had been accommodating. The premium investors demand for holding riskier bonds, think junk, is near an historic low.

Since the post-crisis environment, tighter financial conditions and higher volatility have led to lower equity multiples and lower stock prices. According to Koesterich, “Should volatility rise back toward its long-term average, even strong earnings growth may not be enough to offset lower multiples.”

It is important to pay attention to the bond side of the equation. Because of the low interest rates of the past many years, a lot of corporations borrowed heavily. They have increased their debt by 40 percent since 2008. There is a record $4.3 trillion in lower quality and junk (some call them high yield I still refer to them as junk) bonds.

Additionally, there has been a significant increase in lower quality mortgages being offered once again. If he economy falters and earning decline we may have some serious issues with these bonds. By the way the bond market is larger by about $12 trillion larger than the stock market.

This tug of war makes sense to me. What should an investor do? Continue, as I mentioned in my last article, to return to a more normal asset allocation. If you have too much equity for your risk tolerance now is the time to begin moving assets from that group and add to the bond side.

It would be foolish to buy long-term bonds while rates are increasing. Consider short term, very safe U.S. Treasury’s as well as insured CD’s with maturities of 30 to 90 days. Assuming rates continue to increase these instruments when rolled over will achieve a higher yield with low to no risk. Only later when rates appear to stabilize would we move to longer maturities. I would avoid floating rate corporate bond funds. See above as more than a few of these floaters have lower quality issuers.

We are returning to a more normal environment.

Be patient, be smart and most importantly stay invested.

Michael T. Doll, an investment adviser with the Longboat Key Financial Group, can be reached at 941-896-2473 or michaeltdoll@longboatkeyfinancial.com.