Calm Markets, Crowded Risks
With midterm elections looming on top of the debt buildup in the artificial intelligence space and the interest rate/inflation tug-of-war, there’s a lot of uncertainty out there. It’s okay if you’re not able to answer all your clients’ questions.
On the surface, investors should have little to complain about. The major market indices are at or near their all-time highs as this article went to press. Barring a major surprise in the next 12 weeks, the markets are on track for a fourth straight year of double-digit gains.
Yet I’ve rarely seen so much concern and uncertainty beneath what looks like a calm surface. Think about it. Long-term Treasury yields are now over 5%. The Fed just raised rates and is likely to do so again in December. France is in a social crisis on top of a debt crisis. The midterm elections are coming soon. Yet the market’s fear gauge is barely registering any concern.
The Indices Are Telling Different Stories
The Dow, the S&P 500 and the Nasdaq usually move together. This year, they have drifted apart, a sign that the market is not rising overall. A handful of large technology and artificial intelligence companies are carrying the S&P 500 and the Nasdaq higher. Meanwhile, only 42% of S&P 500 stocks are trading above their 200-day moving average, even as the index sits near a record high. The last time this happened was March 2000. The headline implies good times ahead. But typical stock performance says otherwise.
Narrow stock leadership is not a reason to panic in and of itself. But it does warrant caution. When a market depends on just a few names to provide the lift, the market is only as strong as those few names. If the AI data center financing crashes, there is not much underlying diversification to cushion the fall.
Safe Yield Is Back. Why Aren’t Investors Biting?
For most of the last 15 years, low Treasury rates punished savers, forcing them to take risk elsewhere to earn a decent return. This changed recently. The 10-year Treasury closed near 5.3%, and the 30-year near 5.65%. Investors are moving into bonds in record amounts, but they’re avoiding the higher-yielding long end of the curve.
Why? Long bonds lose value when rates rise, and selling before maturity locks in those losses. Long bonds are not a parking lot for investors waiting to go into the market. A recent Reuters analysis said that 5% yields have “lost their shock value” and investors are now worrying about 6% and the loss of value that will occur in long-bond holdings. Meanwhile, money is pouring into short-term bonds and ETFs at a record clip.
In a Yahoo Finance report, Pathstone’s Michael McGowan explained that we’re not getting enough of a yield pickup and that, with short-term yields relatively high (2-year near 4.4%), locking up money for 30 years doesn’t earn enough extra yield. The same report said UBS’s Ulrike Hoffmann-Burchardi told clients in a recent note that “long-end bonds are likely to stay volatile until inflation and growth show clearer signs of moderating.”
Since no one knows when that clarity will come, my view is that staying short makes more sense. Factors pushing yields higher include inflation near 3.8%, rising federal debt, energy prices tied to Iran, and further Fed hikes anticipated in December.
If your clients are not worried about their bonds losing value, locking in 5% for a portion of their portfolio is not timid. It’s prudent, as it provides steady income while they wait for a market opportunity. For retirees and anyone within 10 years of retirement, this is an opportunity we have not had since before the 2008 financial crisis.
Fourth Straight Double-Digit Year for U.S. Stocks?
Four consecutive years of double-digit market gains are rare. It’s only happened three times before, most recently from the mid-1990s to just before the 2000 tech meltdown, which took the Nasdaq down nearly 80% from its peak, and the S&P 500 down nearly 50%.
The parallels to today’s AI runup are worth noting. Long winning streaks ultimately change investor behavior. Investors begin to view double-digit returns as normal and tune out warnings. Remind clients that markets do not have to crash to hurt you. They disappoint whenever your expectations are too high.
Midterms, the Fed and France
Three events could test this market before year-end:
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The midterm elections. Midterm years have a history of volatility. BTIG analysis notes that in every midterm year since 1990, the equal-weight S&P 500 has pulled back at least 7% from its mid-August level through midterms. Will that happen this year? You don’t have to know the answer; just be prepared.
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The Federal Reserve. After years of debate about rate cuts, the Fed has turned the other way. It raised rates in September, bringing the fed funds rate to 3.75% to 4%, and markets expect more hikes. They may skip a rate hike in October and wait until the Dec. 9 meeting. Inflation is nearly 3.8%, almost double the Fed’s target.
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France. Europe’s second-largest economy is in serious fiscal trouble. French 10-year yields have approached 5%, the highest since 2002. The gap between French and German borrowing costs recently topped 1.5 percentage points, the widest spread since the Eurozone crisis of 2011. Government debt is heading toward 122% of GDP, and political gridlock ahead of the 2027 presidential election makes reform difficult. Pressure has already spread to Italian, Spanish and other European bonds. A crisis in France is unlikely to remain confined to France.
Why Is the VIX So Low?
The Cboe Volatility Index (aka Wall Street’s “fear gauge” or the VIX ) measures how much volatility investors expect over the next month. The VIX has been hovering around the mid-teens and hit a 2026 low near 14 in August, both below the VIX’s long-run average in the high teens.
Why is the VIX so calm with the economic problems growing? Part of the answer is momentum. When stocks keep rising, investors stop buying put options on the S&P. Part of it is complacency. Investors have been rewarded for ignoring bad news for three years in a row. A low VIX does not mean that risk is low. It means investors are not worried about a big downturn. But that is exactly when hedging against a down market is warranted.
What Advisors Should Do
This is not the time to tell clients to sell everything and hide. But it is a good time to ensure your client’s portfolio allocations align with their risk tolerance. Here are three recommendations:
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Rebalance. If three strong years have pushed a client’s stock allocation well above their target, trim it back to their target allocations. Paying a little tax is better than a big swing in the wrong direction.
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Lock in yield. If your clients are more concerned about income than growth, buying into longer-term bonds at 5% might be a good play. For many investors, a 5% guarantee from the U.S. government is a gift.
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Check concentration. Look at whether a client’s portfolio is overly concentrated in certain sectors such as AI. Even ETFs or funds can drift in style, so do a little homework and correct as needed.
After nearly half a century in this business, I’ve learned one thing: Markets reward patience and punish overconfidence. After a long winning streak, advisors should ask investors whether they want to try to make even more money or take some off the table. Answer that question now, while the market is calm and clients are thinking rationally. As advisors, we get paid for bringing wisdom and confidence during times of turmoil and uncertainty. Markets go up, and markets go down. Times like these are when you can really prove your value.
