Optimism vs. pessimism; or stocks vs. bonds

By: Steve Sosnick, Chief Strategist

After a long equity market rally, such as we have experienced recently, it is easy to forget that there are two fundamentally different mind sets at work in the financial universe.  By definition, equity players tend to take a “glass half full” approach to investing, while those in the bond market tend to take the opposite approach.  This dichotomy results from the vastly different risk/reward dynamics investments that are inherent in each asset class.

If you buy a bond, you are primarily concerned with getting your principal back, along with any promised coupon payments that are due prior to maturity.  Your upside is essentially capped – especially if you own short-term paper – but you can be subject to significant loss if the issuer defaults.  Yes, there are opportunities for capital appreciation if you buy long-term or distressed bonds at a discount, but stocks generally offer much more opportunity for significant gains.  

By investing in a product with a relatively capped upside, bond investors are justifiably more concerned with risk than reward.  Bond buyers know exactly what they might plausibly expect if everything goes as planned, but there are innumerable things that can go wrong before then. 

Conversely, because stocks have unlimited upside, those who invest in them tend to be more focused on what could go right.  The vast majority of discussion around the rationale for investing in a particular stock, a sector, or the market as a whole, involves the thesis for that investment.  Earnings will rise, a stock could outperform its peers, the broad indices will perform well because of some catalyst, that sort of thing.  There are those who do point out the risks when appropriate, of course, but the equity investment ecosystem is generally inherently optimistic.

Yet each group of investors can’t ignore the other.  Like it or not, equity people, fixed income lies at the root of the modern financial system.  The concept of a risk-free rate is the basis of every pricing model that I can recall.  Money has a cost.  Of course, it is quite difficult to acquire money – it requires hard work and/or luck – but speaking from an investment perspective, the cost of money refers to the baseline return that one can make in safe assets.

It was easy to largely forget about the importance of the risk-free rate when rates were roughly zero.  The returns on T-bills and bank accounts were negligible, so we could focus more on return than on risk.  Hence the concept of “TINA”, or “there is no alternative.”  Now, with rates in solidly positive territory throughout most of the world – and after some seemingly safe banks have experienced problems – we have needed to rethink how we earn those risk-free rates and the opportunity costs of different investments. 

For a while – the better part of 2022 – equity markets suffered because the cost of money rose dramatically, causing even optimistic investors to become more risk averse.  Lately, however, the optimism has returned.  Enthusiasm about artificial intelligence (AI) was a key catalyst, but that has now spread beyond the original cadre of mega-cap tech winners.  At the same time, an inverted yield curve shows that bond investors continue to fear an impending recession.  Fed Funds futures no longer believe that rate cuts are coming before the end of the year, but with 2-year yields about a full percent above 10-years, a recession is still priced into the bond market.

Is it possible that stocks can be optimistic and rallying at the same time that interest rates remain high and pessimistic?  Sure, that’s what we see now.  Heck, stock investors can weave the potential for recession-induced lower rates into a bullish thesis.  Ultimately, one will prove more correct than the other, but a major divergence can persist for quite some time.  The pools of investors have different enough viewpoints to allow the divergent theses to co-exist for a while.

This post first appeared on June 20th, 2023 on the IBKR Trader’s Insight blog

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