The S&P 500 finished up 2.9% last week after losing 2.2% the prior week, which was its worst weekly performance of 2019. The index is only up about 4% over the trailing 12 months, however, including dividends. Meanwhile, utility stocks – usually considered defensive, income-oriented equity holdings – have returned over 20% during the trailing 12-month period. The Vanguard VNQ ETF, which tracks real estate investment trusts, also considered more defensive in nature, has returned more than 18% over that period. The technology sector isn’t keeping up, having returned only about 5% during the last 12 months, a bit better than the S&P 500 but well behind the utility and real estate sectors. Meanwhile, money is rushing into equity mutual funds, often a warning of a near term top. $14.2 billion flowed into equity mutual funds last week, $12.1 billion came in on Tuesday alone; the fastest rate since Sept 18 of 2018 when the S&P 500 peaked.

(Nerd Note: Of course, there is no cash on the sidelines coming into the equity mutual fund market (see Vol. IX). People are just swapping holdings, changing their asset mix. In this case, the smart money may be selling individual stock holdings to mutual fund companies needing to buy individual stocks for newly created open-ended mutual fund shares. The mutual fund shares are needed to satisfy the less smart money that has decided it needs more exposure to a stock market that is up double digits already on the year. Is dumb money chasing the rally? Perhaps. It’s called distribution by the technical analysts and occurs during a market top – not that we’re foolish enough to call a market top mind you.)

Mr. Bond Market might be calling a top in the stock market, however. The yield on the 10-year Treasury fell below 2.6% last week for the first time since January of 2018. The one-year bond is now 2.536% while three to five-year bonds are yielding less than 2.4%, a partial inversion of the yield curve and a signal of lower inflation expectations that typically accompany lower economic growth. The situation will resolve itself with a pickup in economic growth, validating the stock market’s rise, or a continued slowdown in economic growth, validating falling yields and setting the stock market up for a drop. Stay tuned!

We wrote about inflation and the debt last week. We’re going to continue writing about inflation for the next few weeks because it’s coming back with a vengeance…eventually. We will almost certainly experience a period of high inflation at some point over the next twenty years. It will cause heartache and pain for an entire generation of retirees. Got your attention? Good.

I had a conversation with a friend a few weeks ago. It became apparent that he’s planning his retirement around no inflation. He and his wife are in the process of retiring. They hope to be completely out of the workforce by 2021 at the latest. Although he’s a friend, he’s not the type of friend that shares his financial situation in any real detail. I’ve had to piece together his thought process about retirement over the last few years as we’ve talked about the economy, the capital markets, Social Security, Medicare, and any number of other topics having to do with retirement. The comment he made to me recently, a comment that felt like the last piece of the puzzle, was “if you save enough you can just buy CDs and you’ll be fine.”

My interpretation of that comment was, “Hey, I think I’ve saved enough that I don’t need to invest in the stock market. I can just buy a Certificate of Deposit (CD) ladder out to five years and avoid the volatility and risk inherent in the stock market.” Okay, that’s a lot of interpretation based on, “if you save enough you can just buy CDs and you’ll be fine”, but I know the guy well. He’s extremely risk-averse. He’s got most of his money in his house and the bank. Finally, he’s sat out the longest-ever bull market in our history-making it unlikely he’s going to put a portion of his retirement portfolio into stocks in retirement. 

What’s the problem with his plan?

Inflation is the problem. He’s retiring at 58 (wife 56) and is hoping to spend thirty years collecting interest on CDs while forgoing any real return on his portfolio. It might work if he has saved enough to meet all of his spending needs without requiring a real return on investment (return minus inflation) and inflation stays low. There’s almost no chance of it working if we experience five or six years of rising general price levels that culminate in mid to high single-digit inflation. The banks won’t raise CD rates fast enough to compensate for the lost purchasing power my friend will experience in a rising inflation environment. Remember when Treasury bonds were called Certificates of Confiscation? Right, no one else does either.

We expect that sometime in the next few decades people will remember. After all, the Federal Reserve is on record stating that they want an average inflation rate of 2% over a business cycle. Higher inflation is coming because the government needs inflation to help it pay down the mountain of debt it’s accumulated over the last 15 years. An inflation shock sometime in the next few decades will almost certainly require my friend to change his investment strategy to include stocks. I only hope he realizes it before it’s too late.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist