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Q3 Market Commentary: T-Bill and Chill

The third quarter of 2023 was a challenging one for investors, as both US equities and bonds posted negative returns. US equities lost 3.3% for the quarter, as measured by the S&P 500 index, after a strong start to the year. Bonds also suffered a sharp sell-off, as the yield on the 10-year US Treasury note rose from 3.8% to 4.6% during the quarter, pushing the Bloomberg Bond index to a loss of 3.2% for the quarter and into negative territory for the year.

Year-to-date large-cap growth stocks have significantly outperformed other segments of the market, with the Nasdaq 100 index up 35.4%. Value and small-cap stocks have lagged behind, with the Russell 2000 Value index down 0.5% and the Russell Microcap index down 6.3% year-to-date.

The economy remained despite high and rising interest rates and the consensus of most is now for no recession or a soft landing. The latest real GDP growth number came in at 2.1%. The Fed signaled they expect only one more rate hike in this cycle. So where should investors go from here? How should an investor position themselves in this environment? 

T-Bill and Chill: A Prudent Strategy for Today’s Market

I believe ‘T-bill and Chill’ is the most prudent strategy for today’s market. What is T-bill and Chill? This is a simple investment strategy where you allocate a large portion of your portfolio to treasury bills (T-bills) and avoid excessive risk in other asset classes. T-bills are US government bonds with maturities of one year or less that offer virtually riskless returns. With yields currently exceeding 5.5%, T-bills look extremely attractive in today’s environment. 

Why this strategy today? US stocks look expensive and offer low future expected returns and most bonds provide inadequate returns to compensate for their risk. 

US Stocks Look Overvalued

US stocks are still trading at very high valuation levels that have historically corresponded with poor future returns. One measure of stock market valuation is the CAPE ratio (aka Shiller PE), which is based on average inflation-adjusted earnings from the previous 10 years. The CAPE ratio currently stands at 29, significantly higher than its historical average of 17. 

High CAPE ratios have resulted in poor future annualized returns in the stock market historically. With a starting CAPE ratio of around 29, future 10-year stock market returns have ranged between -1% and 6% in the past. 

Based on this chart, investors in equities should only expect around 3% annualized returns in US equities over the next decade. That makes equities look very unappealing given their risks. 

Fixed-Income Not Properly Compensating Risk-Taking

Riskier corporate bonds and longer-duration bonds aren’t currently providing adequate returns to justify their risks. The yield curve is still inverted, meaning long-term treasury securities yield less than short-term treasuries. For instance, while a 6-month T-bill is yielding around 5.6%, a 10-year treasury note is yielding 4.8%.

Just how much risk can longer-dated bonds have? As the following chart from Jack Farley shows, long-term treasury bonds are down more than 58%, a loss greater than stocks during the Great Recession: 

The spread between corporate bonds and treasuries currently sits at around 1.28. That means a typical corporate bond only yields roughly 1.28% more than a similar treasury security. 

With few exceptions, I don’t believe the additional yield on corporate bonds is worth the additional risk. Especially when the spread is likely to go significantly higher in the event of a recession. The following chart shows the spread between treasury bonds and investment-grade corporate bonds. Note how much higher the spread has been during periods of stress in the past:

In my opinion, T-bills are more attractive than stocks and bonds at these prices. Thus I think it makes sense to underweight both traditional fixed income and equities for most investors. 

Soft Landing Hopes

In both 2000 and 2006, there were more stories on ‘Soft Landing’ on the Bloomberg Terminal than stories on ‘Recession.’ It’s quite typical to see optimism about the economy’s ability to avoid a recession shortly before we enter one. The following chart shows that the number of news articles mentioning ‘soft landing’ tends to peak before recessions:

Further, the following graphic from Michael Kantro shows that news stories touting the economy’s strength can be quite convincing right before downturns:

Today’s environment echoes the past. Recession was the consensus on Wall Street near the end of 2022. As the economy continued chugging along, that consensus has changed and most now believe we’ll have a soft landing or no recession at all. Bloomberg stories on a ‘Recession’ have disappeared while stories on a ‘Soft Landing’ have taken over. 

I first mentioned recession warning signals in my Q1 2022 commentary while cautioning, ‘It may still be relatively early in that process and markets often surprise us.’ In that update, I noted that on average it took 21 months following a yield curve inversion for a recession to set in. I still think that’s the most likely outcome. A recession probably lies ahead but these things take much longer than most expect. My best guess is that it won’t happen until sometime next year.

There are some near-term headwinds for the economy to keep an eye out for: 

Even the Fed cautions that their policy works with long and variable lags. The unprecedented rate hikes are still working their way through the economy. The many recession charts and indicators I put out in my Q2 commentary continue flashing alarms as well. The economy is definitely not in the clear yet.

Conclusion

T-bills are an easy way to ensure your portfolio continues to grow while minimizing risk. With equities priced to deliver poor future returns, I prefer to keep equity exposure to a minimum. Similarly, I think minimizing risk and duration in bonds is the right approach today. Importantly, T-bills provide a call option on future opportunities. If the stock market corrects or yield spreads increase, we’ll be ready to deploy our T-bills into more attractive assets. Until then we will ‘T-bill and chill.’ 

Scott Caufield, CFA, CPA