Minds, they say, are like parachutes; they are only useful when they are open. That is especially true in the worlds of trading and investing, where the realities of markets often contradict your assumptions.
That is the case right now when it comes to current U.S. trade policy. I, like many others, believed initially that the current administration’s aggressive stance on trade was a recipe for disaster. As we get closer to a deal after two years of tariffs, however, markets are telling a different story. To understand that story, you have to understand the theoretical relationship between stocks and bonds.
Modern portfolio theory is a basic tenet of investing for most people, even if they don’t call it by name. It was created by Harry Markowitz in 1952, and has stood the test of time, and involves balancing risk and reward in a portfolio. There are many facets to the theory and it often involves quite complex calculations, but the practical application for most investors is about achieving an appropriate balance in their accounts between stocks and bonds.
That is considered desirable because there is an underlying assumption that those two asset classes are negatively correlated; when stocks go up, bonds go down and vice versa.
That makes sense in theory. Bonds are a safer investment than stocks, so they tend to go up in value when traders and investors are fearful and selling stocks. On the other hand, bonds tend to go down in more optimistic times when stocks are being bought. Sometimes though, theory and practice differ, and now is one of those times.
The 10-Year U.S. Treasury note is currently yielding around 2.5%, not quite as low as earlier in this recovery, but still extremely low on an historical basis. Low yields equate to high bond prices, so the obvious question is how can bond prices be this high when all the major stock indices are themselves close to record highs?
Given the normally inverse relationship between the two asset classes, one reason that both could be so well bid would be if international investors are favoring U.S. assets, both bonds and stocks, over those of other countries. That contention is supported by the fact that the dollar is also high. Demand for American stocks and bonds necessarily results in demand for the currency.
That demand for U.S. assets tells us something about expectations for the trade deal when it comes. Global capital is completely agnostic when it comes to American politics. Money is moved based on realistic expectations for outcomes, and it is only logical to assume that the expectation now is that America will emerge from the trade war a winner, at least on a relative basis.
That could explain why, even as some companies blame earnings misses on trade disruptions and European data suggests slower growth, U.S. stocks keep powering higher. The relative nature of a trade “win” however, would also explain why bond traders are also tilting towards America.
If your politics make the conclusion that Trump was right to disrupt trade unpalatable, there are a couple of other possible reasons for what we are seeing that you can consider. It could be a lingering effect of the distortion of credit markets wrought by the actions of central banks in response to the recession, or it could simply be that the market is wrong.
The first could be true, but it still doesn’t explain why this is happening now, as a deal looks imminent. If you want to believe the second, go ahead, but keep in mind that betting against some of the world’s smartest, most informed people is rarely a good idea.
The logical conclusion to all this is that investors should not be scared by proximity to all-time highs and should still favor U.S. stocks over other investments. More importantly, what it also points to is that traders and investors should follow the flow of capital and listen to its message, even when that message contradicts their opinions and biases.