A lot can change in a month's time and a lot has in many pockets of the capital markets.
- The iShares Micro-Cap ETF (IWC) has increased 10.1%
- The S&P 500 financial sector has increased 8.5%
- The Russell 2000 has increased 7.5%
- The S&P Midcap 400 Index has increased 5.6%
- The yield on the 10-yr Treasury note has increased 30 basis points to 2.36%
- The U.S. Dollar Index has increased 1.7% to 93.88; and
- The CBOE Volatility Index has collapsed 13.8% to 10.03
A concise analysis of matters would indicate that the last 30 days has been a very good period for the stock market, which has featured record highs for the major indices, broad-based participation in the breakout to record highs, and a pervasive sense that the glass is more than half full for the stock market into year end.
It hasn't been so great for the Treasury market, which has come unwound a bit on the unwinding of safety trades.
What has precipitated the sudden turn higher (lower) for the stock market (Treasury market)?
- Relief that Hurricane Irma did not cause as much property damage in Florida as feared
- Relief that Congress agreed to extend government funding and the debt ceiling for three months, thereby avoiding a government shutdown
- Renewed optimism that tax reform can be achieved soon
- The arrival of some encouraging economic reports; and
- Some momentum-based trading activity rooted in the stock market's resilience to selling efforts and the fear of missing out on further gains
...and then there was what Warren Buffett said.
What He Said
In an interview with CNBC on Tuesday, October 3, Warren Buffett shared a lot of insight, yet he said two things in particular that surely resonated with bullish-minded participants:
- Stock valuations make sense with interest rates where they are. He added that if the 10-yr yield moves up to 5% (it is 2.36% today), then he'd be inclined to think that stocks would be "somewhat cheaper"
- He acknowledged that Berkshire Hathaway is holding off on selling, because it is waiting to see if there will be a change in the tax code that will enable Berkshire Hathaway to realize gains at a lower tax rate
Those were some remarkable statements from the world's greatest value investor who has never been inclined in the past to let politics dictate investment decisions.
This time, however, is apparently different since Mr. Buffett believes the probability of passing a tax plan is higher than most people think; hence, he would feel foolish in hindsight with a decision to sell now if he ultimately could have benefited from a lower tax rate a few months from now.
Sitting on Selling
If you are wondering why the stock market has been so resilient to selling efforts of late, we think Mr. Buffett verbalized a key reason why. A lot of institutional account holders are literally sitting on long-term capital gains, reluctant to sell in front of a potential tax cut agreement.
That doesn't necessarily mean the stock market is going to go vertical into year end (even though it could), yet we think it means any material setback is likely to be avoided absent an exogenous shock.
As an aside, if a tax deal gets done before the end of the year, don't be surprised if 2018 gets off to a soft start as long-term holders embrace some pent-up profit-taking activity.
Be that as it may, it would be remiss not to point out that Mr. Buffett sees quite a buffer still with interest rates before stocks encounter some real competition from bonds.
That shouldn't be interpreted as a blind endorsement to buy any stock and that nothing can go wrong until the 10-yr yield hits 5%, yet it is an interest-rate line that has been drawn in the sand that will keep some investors wedded to their bullish bias.
Keep in mind, however, that Mr. Buffett thinks stocks could be somewhat cheaper if the 10-yr moves up to 5.0%, not just when it hits 5.0%.
Others have set a lower bar for when interest rates might prove problematic for stocks. For instance, Jeffrey Gundlach, founder and chief executive of DoubleLine Capital, who is widely respected in his own right, said at the end of last year that he thinks a 10-yr yield above 3.0% will be a problem for stocks.
What It All Means
Rising interest rates will provide some competition for stocks that has been missing for some time -- a lot longer than many people expected, including Warren Buffett.
The latest back up in rates, which has been pretty sharp, hasn't been problematic for this bull market for several reasons:
- Despite rising 30 basis points over the last month, the 10-yr note yield is still 12 basis points lower from where it began the year
- The current yield on the 10-yr note is still comfortably below the 3.0% threshold that some, including us, think will thicken the plot for this bull market
- The backup in rates has been embraced by the stock market as an encouraging sign of economic activity and earnings prospects
- It has fueled a value-based rotation into the heavily-weighted financial sector; and
- Warren Buffet threw a verbal safety net on the stock market with his acknowledgment that Berkshire Hathaway isn't selling its investments until it sees what happens with the tax plan
There is a rising belief the stock market can handle another interest rate hike from the Fed, too. How do we know?
A month ago, the CME Fed Watch Tool showed only a 37.4% probability of a rate hike at the Federal Reserve's December FOMC meeting. Today, that probability stands at 93.1%, and on its way there, the major stock indices all logged new record highs.
A lot can change in a month's time, yet the bull market for stocks has remained a constant.