Stocks continue to provide extraordinary returns. Bonds are flat. Inflation is a worry. Here’s the data:
Stocks
A great quarter for stocks. All indices are up big. The riskier US Small Cap and Emerging Markets indices led the way, although all market indices are well above long-term averages. The average return of the Magnificent Seven stocks was 10%, a drag on the S&P 500, which has been unusual.
Except for the S&P 500, the five-year returns of other indices are generally consistent with market expectations. Keep in mind that to realize these returns, not only was it necessary to earn the extraordinary results of the past twelve months, it was also necessary to endure below average returns in other periods – evidence that stocks are variable (risky) over short periods.
Our Global Stock Portfolio is up 25% over the past twelve months – well above past averages. Yet, returns at this level are not unprecedented – a little more than 10% of the historical twelve-month periods were better.
Bonds
Not much is happening in bond markets. Yields are up at intermediate term maturities. Bond returns are essentially flat this quarter.
A Perspective on Inflation
The accompanying chart shows inflation since Covid. It may provide some perspective on today’s inflation expectations. Note how inflation ratcheted up to 9%, but came back down to a manageable 3% over the two-year period from March 2021 to March 2023. Whether that’s “transitory” is in the “eye of the beholder.”
Today’s worry is cost push Inflation due to the Iran war and the closing of the Straits of Hormuz. The concern is the extent to which it becomes embedded in economic decision making. See how inflation has ticked up in the past twelve months. However, inflation expectations have not shown up in the spread between nominal and inflation adjusted yields – remained at about 2.2%.
Efficient Markets and “Bubbles”
If a market is “efficient,” then observed prices reflect all relevant information; changes are random, active money managers don’t produce above-market risk-adjusted returns, and prices respond quickly to news. These observations hold up well empirically. The Efficient Market idea has been around since the turn of the last century when Bachelier (a French mathematician now thought to be the father of mathematical finance) observed that grain prices behaved like a “drunkard wandering from lamppost to lamppost.” While often met with derision, this hypothesis hasn’t been replaced by a more compelling description of market behavior.
While “bubble” is a popular description of what we observe in today’s market, there can’t be “bubbles” in an efficient market. Yet, there seem to be periods when markets become unhinged from reality. The Space X IPO is a recent example. These periods are difficult to reconcile with markets that are pricing assets efficiently. However, often what looks like markets being out of whack can be rational pricing of a vastly uncertain future by risk-averse, profit-maximizing traders. This pricing process can produce sharp swings, making it difficult to reconcile observed price behavior with a rational process.
So, is what we have today a “bubble” or investors seeking to price a uniquely uncertain future? Take your pick!