Following the presidential election, the S&P Stock Index rallied nearly 10% in about five weeks, but remained paused since the middle of December. During that same time, the 30-year government bond went from 2.6% to 3.2%, one of the fastest historical rate increases, while the market priced-in increased inflation expectations.

This rally is the largest post-election gain in the S&P 500 since 1967.  But this aging bull-market and extended economic recovery are not without a few significant problems.

One problem would be lofty stock valuations and overly optimistic investor consensus. A second one is the pending interest rate increases by the Federal Reserve. Three more rate increases are expected this year. Another negative market omen is that stock market seasonality in the first year of a new president is historically a negative one.

However, the December Consumer Confidence Board Index showed the highest confidence by consumers since August 2001 as seen on chart below. Another leading indicator shows that market breadth continues to climb to a new all-time high, confirming the stock market new high and pointing to favorable prices ahead.

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The yield differential between high yield bonds and US government bonds is currently only about 3.8%. This indicates that the yield on high yield bonds is paying 6.3%, where 10-year government bonds only yield 2.5%. A normal range for this yield spread is between 3% and 7%. The lower this number is, the lower the potential returns are.  Looking at what happened in 2004, when we were midway in an economic expansion and the yield spreads were about where they are today, the charts below illustrate the returns for the three years following this similar economic period. Total returns for the next few years averaged about 8.5% annually for high yield bonds. If the yield spread continues to drop, high yield bonds should continue to appreciate, but if this spread drops below 3%, a defensive strategy is likely.

*The CSFB High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.

This blog contains excerpts taken from the January 2017 edition of The Full Spectrum newsletter. To continue reading please download the full copy here: The Full Spectrum: January 2017


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