The old adage that the market climbs a wall of worry is rooted in historical evidence. History shows us that the prevailing climate during powerful rallies is most often one where conditions are still negative and the majority of investors are bearish and pessimistic. The stock and corporate bond markets have been climbing a wall of worry since early March.

On Friday, the Bureau of Labor Statistics reported that the United States lost a net 247,000 jobs during the month of July and registered a 9.4% unemployment rate. The stock market, measured by the S&P 500 index, rallied 1% to a new high for the year, bringing the rally total to a 50% gain
since the low on March 9. The employment report was the best reading on job losses since before Lehman Brothers failed in September of last year— the event that precipitated the peak of the financial crisis.

Certainly, the news was a welcome sign of improvement. However, corporate and high yield bond spreads are already back to pre-Lehman levels, signaling much of the recovery evident in Friday’s data has already been priced in. Once a recovery has been fully priced in, there is no wall of worry left for the markets to climb. We aren’t there yet, but we may be getting close.

After an extended period when bearishness prevailed, the American Association of Individual Investors survey reflects a change in sentiment during the past two weeks, with more investors now bullish than bearish. An environment where many investors remain bearish and have yet to buy in to the improving backdrop is an essential ingredient to climbing the wall of worry. Does the survey indicate that investors have become too positive? Not yet. Although the bulls outnumber the bears by the widest margin in over a year, the spread between bulls and bears remains less than it was at the end of stock market rallies during the past several years.

The turnaround in sentiment has been remarkable. Investors have gone from pricing in a depression to a typical recession to a recovery in just five months. The wall of worry that seemed insurmountable to most in March has turned into a stairway to heaven. However, the next steps may lead to the return of inflation. Too much good news on the economy and conditions in the credit markets could turn out to be bad news, since it may give rise to inflation pressures and force the Federal Reserve to begin to exit the extraordinary strategies that have been critical to the recovery. For example, the yield on the 10-year Treasury rose after the labor market
data was released and was up a big 40 basis points last week. The rise in Treasury yields may lead to higher mortgage rates, which could weigh on the recent stabilization in the housing market. In addition, the Fed funds futures market moved to price in a greater chance of rate hikes within the next couple of quarters. The statement issued from the Fed meeting this week, on August 12, will be scrutinized for any signals on the exit strategy as the Fed attempts to keep inflation fears in check. If the Fed’s exit strategy is implemented too early, the recovery may not be self-sustaining.

Notably, the dollar rallied on Friday, suggesting the market’s moves resulted from the improving outlook for growth not yet affected by concern over inflation. If the return of inflation were a significant issue for investors, the dollar would have declined.

The evidence suggests that the stock market still has some additional upside even after the 50% gain and that inflation concerns have not yet capped the rally. But what about corporate bonds, especially high yield bonds—have they come too far too fast?

There have been two divergences between the direction of high yield bond spreads and the S&P 500 since the stock market peak in October of 2007. The first of these took place late last year as high yield bonds overreacted to the negative news surrounding the pending auto bankruptcies then corrected back to the path of the stock market. The second is currently taking place as high yield bond performance has soared with spreads coming back to pre-Lehman failure levels, yet the stock market rally has not been as powerful; stocks remain well below the levels that preceded the failure of Lehman Brothers.

If high yield bonds have again overreacted—this time to the positive—then performance may suffer if spreads widen to the level implied by the S&P 500. Alternatively, it may be that the return of liquidity means that solvency of the banking system is much more certain along with the likelihood of borrowers to make debt payments to bond holders, while the return of profit growth that would flow to shareholders is still somewhat uncertain. We believe the latter explanation of the performance disparity is the most likely. The healing in credit markets is unlikely to reverse significantly enough to cause a material widening of high yield spreads while their 8% yield advantage over Treasuries provides for an attractive investment.

We continue to recommend high yield bonds and stocks, especially small cap and emerging market stocks, maintaining the exposures added during the second quarter.