Given the popularity of our weekly Market in Pictures, we started the habit of picking out a few and going into more detail with our PMs. In this edition, John Luke and Dave spend a few minutes on each of the following:
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- Borrowing Costs Going Up
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- One Year from the Lows
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- Government Spending
3 Minute Read: Executive Summary
Full Transcript
Derek
All right. We are live. It’s not quite November, but we’re going to recap October because we got a lot going on in the coming days. Obviously, there’s an election next week and a Fed meeting, so we brought the crew on. Dave Wagner, Head of Equities. John Luke Tyner, Head of Fixed Income, and we’re going to go through some of the charts. There’s a lot to pick from, and it’s kind of hard to get it down to three, so we might have five, but we’re going to roll with that. A couple of them tie in together.
So I’ll do a quick disclosure. The opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information about Aptus’s investment advisory services can be found in its Form ADV Part 2, which is available upon request.
So I’ll go to the charts and let the smart guys talk. I don’t know if you have any overriding thoughts, but we’re kind of just getting into earnings season, Dave, so I know you probably have a lot of stuff to pay attention to in the next few days.
John Luke
Yeah. No doubt. Earnings, election, Fed meeting, jobs print on Friday, you name it.
David
GDP today.
John Luke
You name it, and it’s coming out.
David
One of the craziest things that I’d say, and John Luke, better number before we get started here is that, for the first time in probably 10 or 12 years, that realized volatility on earnings days greater than the implied volatility. So it just tells you that the market may only be up a percent, percent and a half by the end of this month, that there’s a lot of moving pieces underneath the hood of the S&P 500 right now that’s causing a lot of craziness, or a lot of funness, depending on how you look at it.
Derek
Are we behind the normal schedule for these releases? I mean, we’re almost into November, and it seems like we’re just starting to pick up. Is that the norm?
David
It does tend to be the norm. In fact, basically Q2, Q3, and Q4, when the earnings occur for the previous quarter, that this is the normal cadence. I would say that the first quarter, as books really start to close their full calendar year performance, it does tend to be about a week after this. So it actually is on normal cadence right now. The weird thing for this earnings season is that all the big dogs, Microsoft, Amazon, Google, etc. are reporting within the same week. For the past few quarters, they’ve been reporting over a two-week standpoint.
Derek
Got it. All right. Well, lots ahead. Maybe some of that vol will become realized in the indexes too. All right. Well, this first one looks like a JL special, talking about the cost of borrowing. So you want to walk us through this one?
John Luke
Yeah. So the last 24 months really we’ve seen the yield curve be inverted, so the front end of the curve had a higher yield than the long end of the curve as the Fed raised rates. And what you’ve seen is the long end was much lower because the market’s forward-looking, and it’s expecting that at some point in the future, the Fed was going to cut rates, and that would impact longer-term interest rates. And there’s been a number of other things that we’ve highlighted.
But basically the ten-year term premium is what the market requires to get paid in order to buy a longer-dated bond instead of just rolling over shorter-dated Fed funds or six-month treasuries, etc. And what you’ve seen the last, really since the fed meeting in September, is the term premium, especially going into the election, has spiked. And you’ve seen the curve un-invert, so the long end has risen as the front end has come down a little bit. Actually since the fed meeting in September, the two-year’s up about 55 basis points with the ten-year up about 65 basis points. Not really what you expect when the Fed cut rates, for rates to then move up to that extent.
But one of the big pieces of term premium not only is supply and expectations for future inflation, but is also just volatility. And what we’re seeing is substantial volatility going into the election as the betting odds and the polls are somewhat favoring President Trump having a second term, and with that could be GOP control of both the House and the Senate. And I think the market could see that as potentially being in a backdrop of more deficit spending and more growth. And really that’s kind of leading these longer term yields higher. Obviously we don’t know what’s going to happen with the election. A lot could change, and things I feel like tend to get overblown. We’ve seen that happen many times the last couple of years with rates and expectations.
So at the end of the day, I think term premiums should continue to go up because we’ve been supplying and issuing a lot of the debt on the front end of the yield curve instead of the long end. So the supply on the long end has been lower, which has I think exacerbated some of the term premium and bringing it lower than it probably should have been. So really the main point here is we’re seeing some normalization of term premium. We want to see the curve upward sloping. I think that the neutral rate’s going to be somewhere between 3% and 3.5%, so that’s what the Fed is going to cut to likely over the next, call it 18 months.
But with that, it probably means that we should have some term premium for the longer parts of the curve, the five-year, the seven-year, the ten-year, and on. And I think what you’re seeing is a lot of what we talked about the last several months of, number one, markets front ran a lot of the move before the Fed cut, and rates have backed up pretty drastically since. But also that, in the chart we’ve put in many presentations, the return that you get from a bond is typically just the interest rate that you’re receiving on the initiation of when you buy it. And I think people have gotten a little bit too giddy with expecting bonds to not only pay you interest but also go up in price, and I don’t think that’s likely for the foreseeable future as long-term yields continue to be pressured higher.
David
I would say that the term premium or the cost of borrowing, it’s just been very negligible for the past 12, 13, 14 years ever since quantitative easing came into play. And that’s what you kind of see on this chart here. So it is somewhat of a new phenomena, but if you want to bring it back to the allocation itself as to why this is important, I would say I’m the equity guy here. John Luke’s the fixed income guy. This market, whether it’s last quarter or month to date here in October, it’s all about fixed income. I can care less about equities. You need to be looking at the fixed income market to kind of dissect what’s going on with the market as a whole.
But back to allocation, it just shows you how difficult it is to time the market, whether it’s on the equity side of things or on the fixed income side of things. I mean, at one point back in April of this year, you had a ten-year close to fives. In middle of September, you had it to closer to 3.6%, and we’ve rebounded from the Fed meeting at 3.6% to 4.2%. And that’s just on the two-year, and you get even more wild moves on the ten-year. As a whole, it just shows that timing the market is really hard. It shows you that if you have the right structure in place from an asset allocation perspective, you can make less calls and be right more often.
Derek
Just a quick thought and question on this because it doesn’t necessarily apply to allocations, but Dave, I know you spent a lot of time studying home builders and JL, you know how the mortgage curve works. So I think a lot of people were caught flat-footed when mortgage rates, which were coming down, just completely reversed course, and it seems like housing is pretty well frozen right now. There’s just not a lot of activity. Maybe you could just quickly touch on maybe what you’re seeing or what goes into those mortgage rates because they are at a pretty good premium even to this.
John Luke
Yeah, 30-year bank rate mortgage right now is at 7.24, got down to mid-sixes going into the Fed meeting. Definitely has had an impact on real estate and just the financing part of buying a home, especially given prices are pretty elevated. But that definitely shows that the treasury market is one animal in itself, and the mortgage market is definitely priced off of where treasuries are. But between the 30-year mortgage, which typically tracks pretty closely to the ten-year treasury, there is a huge spread there. It’s much bigger than what it normally has been.
And I think that there’s just a scarcity of dollars, right? There’s less lenders that are willing to step in. You had just a huge backdrop of the Fed and other central banks buying mortgages and suppressing the rate way more than it should have been. And I think what you’re seeing now is difficult to stomach, especially if you’re buying a home. But I think it’s more or less how it should work. It’s just not something that we’re used to, and I think the market will have to digest it a bit.
So we are at a 300 basis point spread basically between where the 30-year mortgage is and the ten-year treasury. We’ve seen that get as low as 100 basis points at different times, so a lot of it has to do with who’s buying mortgages and the bank demand and things like that. But my expectation is that the Fed will probably start back with some type of QE or at least completely stop QT in the early part of next year. And so, maybe you see that create a little bit of support to mortgages and keep them from going up much higher.
David
Simply said, that just means that it’s probably a very difficult environment to be a realtor because as John Luke’s saying, we are pretty firm believers that the term premium has entered stage left and that rates are going to be higher than what we’re used to for much longer.
John Luke
Yeah, I don’t think the ten-year is going to drop drastically. If you get some support from mortgages, it’s going to be more than that 300 basis point spread just consolidates a little bit.
Derek
Makes sense. Well, let’s move over to stocks. You have two slides here, and I guess we start with this one that kind of sets the whole thing up, Dave. But it’s been a pretty good 12 months.
David
I mean, we could sing the Happy Birthday song for the market twice because we’re coming off of as of 10/27 of this month, the one-year return from the recent market correction. But not only that, if you actually zoom out a little bit further, October of 2022 saw the recent bull market bottom. So you could actually say that we’ve had our second anniversary to the bull market, and you can think about that in terms of that the bull market has been reset because of two different reasons. We haven’t had a 20% technical pullback in the market. We haven’t had two straight quarters of negative GDP. That’s how I like to look at things.
So I think that that’s a very cool thing to look at here. How has this market performed off of previous corrections looking one year into the future, and how does it rate versus history? Because I think we all believe, and you all have heard us talk about our asset allocation, how we want to do better in the tails, the left tail during market pullbacks and also the right tail when the market just feels like it’s ripping. And everyone thinks that this one-year performance is an anomaly. Well, in fact, it’s actually not. It is in the top 10 percentile from a correction perspective if you look at it from the S&P 500, so it’s been a very strong return of just over 40%. But that’s somewhat normal after these collects.
And Derek, if you go to the next slide, I think if I want to focus on something that feels abnormal in this type of rip-roaring bull market after a recent correction, it’s actually small-cap performance. I mean, if you go back to any Finance 101 class, they’ll say that small-caps, given the risk premium, tend to lead off of market bottoms. But that hasn’t occurred actually during this period of time right now. If you remember from the previous slide, the S&P 500’s return off of the one-year October 27th, 2023, bottom was over 40%. If you look at it for this year, small-caps are up about 35%, so trailing large-caps by 6%, and that’s an anomaly. That’s something that we’re not accustomed to. But even if you compare small-caps, not just against relative to large-caps, but then you compare to its historical performance off of market correction bottoms, the average return is about 60% over the following 12 months.
So I do love small-caps. Everyone on this call knows that. A big believer of it for multiple reasons, but I think there’s some rationale why large-caps have outperformed small-cap off the bottom. Obviously there’s a ton of AI exuberance going into the market, and that’s where you’re getting the concentration to that exposure or narrative in large-cap land. You don’t really get that exposure in small-cap land because I would say that a lot of companies nowadays, they’re not going public until later on in their tenure from a business perspective, that they’re going IPO-ing in the large-cap land, not in the small-cap land. So you’re really just not getting the narratives that have worked in this market over the past 12 months in the small-cap land itself.
I would say that large-caps have outperformed small-caps for another reason, and this actually might be the more important reason, is that large-caps, they actually have operating leverage. Domestic US large-caps are one of the few indices in the world that benefit off of operating leverage. Small-caps are more CapEx-intensive, they’re more service-oriented. International markets, especially on IFA, they’re more service-oriented. If you go more EM-based, they’re going to be more commodity-oriented. While domestic US large-caps, they have operating leverage, meaning that for every input of one input of revenue, they can get greater than one unit of earnings per share.
And I think if you look earnings per share growth for the S&P 500 in 2025, it’s just a perfect example of this. EPS is supposed to grow for the S&P 500 from ’24 to ’25 by 15%. That’s bottom line. But if you look at top line growth, top line supposed to grow only 5%, which is actually a very, very healthy number. But the output given the operating leverage allows you to have earnings growth of 15%, so you’re actually having a lot of margin expansions. That’s at the basis of the definition of operating leverage or the utilization of economies of scale. So I’m actually really not surprised by this performance from small-caps versus large, even though it is an outlier.
I would say one more thing here, and sorry to commandeer and filibuster the conversation. But as we head into this market election, I think a lot of clients are probably asking y’all, or at least they’re climbing that wall of emotional volatility and worry. So I think I want to give you guys, much like our quarterly market presentation deck, as many arrows in your quiver to keep your clients invested. And the best way in my opinion to do that is show them factual information. And I know it’s not a chart or a graph, but if you look at the right side of the slide here, it’s really just talking about the historical performance from a median basis perspective of different asset classes, the S&P 500, the NASDAQ and small-caps, their return from October 27th to December 31st. October 28th is actually from a seasonality perspective, the best day for market performance over the span of the 250 trading days within one calendar year.
But not only that, the fourth quarter tends to see some of the best returns throughout the entire calendar. In fact, from end of October to April tends to be the best perspective from a market-oriented aspect from a seasonality perspective, positive seasonality. But if you look at it in years of election instead of just the normal average year, the performance from October 27th to December 31st is actually much better during election years than non-election years. So I think given the amount of liquidity coming into this market right now, whether it’s from the fiscal side in Washington DC or the monetary side with what the Fed’s doing, it’s just really hard to be short this market when the liquidity spigot has been opened and it’s just not being shut off anytime soon. So remember, it pays to be patient and not clever during these market perspectives, and the best way to show this to clients is through some of these statistics.
Derek
And one chart that we didn’t include here, but I’ve seen you share it a number of times is, I mean, basically a lot of that large-cap, mega-cap move was, you could say it was justified by profits on the large-cap side versus small-caps. But I think, I don’t know if this is still the case, but you’ve shown the slide that basically, whereas you had large-cap earnings growth up here and small-caps were kind of flat, that gap seems to be shrinking a little bit. Is that still the case going forward or the hope going forward?
David
It’s definitely the hope going forward, in my opinion, that you’re starting to see a confluence of the large-cap earnings growth and the small-cap earnings growth, but it’s more just a product of large numbers. These mega-cap companies just can’t continue to grow at the 60% that they did a few quarters ago, and over the past few quarters, it’s been closer to 30%. So the comps that they’re having are becoming much more difficult, and that’s more of the rationale and genesis of why you’re starting to get equilibrium between large-cap and small-cap growth. It’s not because small-cap growth is getting substantially better, it’s just large-cap growth is getting harder to come by. It’s still there, it’s just not coming at the exact same size, scale, and ability that it has over the past few years.
Derek
Makes sense.
David
Obviously we’ll get more of that coming out of earnings season. We have large-caps this week, and then large-cap earnings tend to be followed by small-cap earnings. So I think we’re going to get a lot more understanding of where that confluence is going to happen and at what point because a lot of management teams during the third quarter of the year, or at least when they’re reporting third quarter, they tend to give their fiscal guidance for the following year.
Derek
So speaking of liquidity and elections and all the other goodies out of DC, this is kind of a fun one. JL, it looks right up your alley.
John Luke
Yeah, this was a chart I was kind of surprised to see anyone put out, especially from a big bank. But the gist of this chart is the US government has now become the third-largest economy in the world if you look at their expenditures. It’s a $6.8 trillion economy, but the crazy part is it’s up over 50% this decade, and that means it’s grown at about a 9% annualized rate, which is faster than China or India, two of typically the fastest growing economies. A lot of it’s because of populations, things like that. So US government expenditures as a percentage of GDP is 44% right now. It looks like, I think they put 2033, but it’s supposed to be 2023 in the chart there. But you can see it’s down from the peak during COVID when all of the stimulus was going on.
But the big eye pop there is, when you think about the government’s significance or their role in the economy as someone that believes more in free markets, the government should be there as a backstop. That’s what you typically see the Fed during wars, during recessions, during, heaven forbid, depressions in the economy. And they sort of step in during those periods to help keep the market and the economy and jobs from just kind of going down a death spiral. And so, you see that through the Civil War and more World War I and World War II where government expenditures took huge spikes and then the financial crisis and then COVID of course. But what I think is the most surprising is just the amount of government spending that’s going on right now with unemployment near 4%, which historically is a full employment type of number. And with the nominal growth from a GDP perspective, darn near a six handle from the growth perspective.
So we’re in a backdrop where government’s kind of drowning out some of the private sector, and obviously that’s a problem. You’ve seen more and more of this come up in concerns the past couple of weeks with the polls changing and what that looks like from steps moving forward. You’ve seen Chairman Powell come in and address that the fiscal situation needs to be addressed, and they need to do something about it, but it’s not his job. You’ve even heard Janet Yellen, who arguably is on the totally opposite end of the political spectrum of J. Powell, even make big concerns about the deficit numbers and the direction. So the government from a US perspective, from a spending, from a hiring perspective is driving a lot of the ship.
And if you think about a lot of the expenditures, to take it kind of a couple steps further, whether it’s Social Security, whether it’s the pay of government employees, a lot of it is indexed to inflation. And so, as those numbers go up from an inflation perspective, the government expenditures will rise as well. So there’s a lot of things that, not only just the spending moving forward, but the past spending as it adjusts higher with inflation and over time, it gets to a point where it’s difficult to address.
And the way out that we always talk about is some combination of growth and productivity from the private sector, and I think that would be the golden ticket to get debt-to-GDP back from 120% to 70% or 80% where it’s historically kind ridden. And with that, you’re going to need an environment of really strong nominal growth. And so, I think that what this is just another hit on is the importance of asset allocation and the confiscation effectively that fixed income is very, very likely to play on investors’ long-term portfolios. And it injects a lot of longevity risk into their future and into their retirement, into their plans. And it probably means that you need to increase your inflation expectations in those plans because I think 3% or four 4%s more likely the next decade than 1% or 2% like we saw the last 10, 15 years.
Derek
Yeah. Doesn’t appear as though there’s a whole lot of appetite to change that trend.
John Luke
Yeah, neither party is anywhere near touch in talking about the deficits. Both have different plans, I think, but both of them want to bring a lot back to America and reshore and have manufacturing in the US. So a lot of those things are geared towards growth, but I think that they’ve kind of figured out you don’t get fiscally responsible to get out of this. You grow out of it, and you inflate out of it.
Derek
Which ties into Dave’s area of got to have growth. You always say on every one of these calls, the biggest wild card is growth. We need it. And obviously if we’re going to spend like that, you need it.
John Luke
Yeah. Well, I saw an interesting stat, and I don’t want to drag this on anymore than we have with some long-winded commentary for me already, but 1995 and 1997 saw similar types of markets of what we’ve seen this year, where returns were really high and the volatility of the market was really low. But what was surprising? So ’95, the S&P was up 34% and in a very low volatility environment. ’96, the S&P was up over 20%. And then, in ’97 you had another environment of very nice returns with low volatility, and ’98 followed it up with almost a 27% return on the S&P.
And so, not only does low vol sort of not necessarily point towards more volatility in the future, it could be really good for markets, but now you’ve got a backdrop with the government being a big driver of expenditures. Their deficits are somebody’s surpluses, and it’s flowing into the private markets, it’s flowing into consumer’s balance sheets, etc. And so, I think it is just, Dave said this better than anyone, but it’s very hard to be bearish going into the election. And I would say it’s very hard to be bearish going past the election and into the end of the year, and into next year too.
David
John Luke, are you saying that a bubble ends this current run? You’re going back to ’95, ’97, ’98?
John Luke
I think we grow out of this. We’re going to need nominal GDP growth at like 7%, 8%, 9% for five, six years. And then, you look back, and we get back in a situation where things are better.
David
I thought you were going to call me out for trying to bait you there.
John Luke
No, no bubbles.
Derek
Awesome. Well, cool, guys. Thanks for talking through this. There’s going to be a lot of content coming shared along with this in the coming days. There’s going to be a lot to talk about, so you know where to find us, and we will share as things get published. So thanks for tuning in, and we’ll talk to you again soon.
John Luke
Thank y’all.
David
Cheers.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security.
The opinions expressed are those of the Aptus Capital Advisors Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed.
Aptus Capital Advisors, LLC is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. For more information about our firm, or to receive a copy of our disclosure Form ADV and Privacy Policy call (251) 517-7198. ACA-2410-32.
