Yesterday, in response to advisor requests, my post summarized some of my high-level thoughts about the state of the economy. To recap my take briefly, the economic risks of the pandemic are largely in the past. The economy is growing, and markets are strong. Given this environment, the risks of governmental action (notably the infrastructure spending bills) and the Fed’s policy accommodations are now bigger worries than the pandemic. In the face of these risks, can our economic growth continue? My base case is that we’re getting closer and closer to normal. So, today, I want to address how we can invest in a growing economy that faces risks of inflation, higher interest rates and government policy changes.

Are Markets Seeing A Sugar High?

The first step is to understand where the markets are. If we set aside the pandemic, the markets look pretty normal—very much like what we would face in any growth environment. When an economy is growing, and doing well, more demand can generate inflation. At that point, the Fed will raise rates, and the government will likely respond as well. We are right in the middle of this scenario. But is there anything that would make this market cycle different?

There may be. The biggest possible difference is that a case can be made that much of the current economic expansion is based on federal stimulus payments, rather than organic growth. The expansion will end when the stimulus payments do. In other words, with the economy and markets both rising, is this just a sugar high, rather than a sustainable expansion?

Rise In Demand Looks Sustainable

I don’t believe we’re seeing a sugar high.

First, while the stimulus payments did indeed stimulate the economy, we are now well past them, and growth has continued.

Second, with the growth in jobs and the rise in wage income and consumer confidence, consumer demand and purchasing power have continued to grow, supporting more spending growth.

Third, we are seeing the same thing in business confidence and investment. Overall, earnings are strong enough to keep consumers and businesses spending and confident enough to keep doing so. If current conditions hold, this trend is sustainable.

And this rise in demand, which now looks sustainable, is why markets have been moving higher. But this brings us to another concern: even if growth continues, are the markets too high? If so, will we see a significant pullback?

The main reason for this concern is stock valuations, which are now very high historically. Depending on the metrics used, valuations are, in some cases, at all-time highs, even exceeding those of the dot-com boom.

Why Equity Valuations Are High

I don’t think high valuations are an immediate problem for two reasons.

First, valuations have been high for the past five years and more, suggesting this trend is a systemic change rather than a spike.

Third, within this change, stock prices have changed consistently with earnings expectations, suggesting that the market is behaving rationally—but within a higher value range.

In other words, until interest rates increase materially, stock prices are likely to be supported in the current range. They will respond to changes in earnings—which is just what we have seen so far. And even when rates rise, assuming the increase is measured rather than sudden, that does not mean the markets will drop. In past expansion cycles, rising earnings have usually offset the effects of rising rates, allowing markets to keep going up. So, the high markets are something to watch—but not panic about.

Risks For Fixed Income

A related topic is whether fixed income faces similar valuation risks. With rates low, bond prices, like stock prices, are high and potentially vulnerable. But the risks are larger for bonds. I’ve talked about focusing on credit for return, rather than bond duration. Duration is a risk that can and should be managed—but, again, it is nothing to panic about.

The related risks between stocks and bonds call into question whether a 60/40 portfolio still makes sense. Here, the issue is somewhat different. Yes, the risks of stocks and bonds are now related, but that is not the issue. The question we need to answer is why we have fixed income in a portfolio. Despite those related risks, the reason has not changed. Fixed income is meant to provide a portfolio with diversification and risk protection. Despite low rates and high valuations, in the event of economic trouble, the responses of equity and fixed income are still likely to be very different. As a result, a diversified portfolio should provide real benefits when trouble hits. When considering the 60/40 portfolio, we should discuss how we diversify, and the best way to do so, but the need to diversify has not changed.

How Do We Invest Under Current Conditions?

As I mentioned earlier, the challenges we face today are, in many ways, the same as those faced in any growth environment. Growth breeds higher earnings and higher valuations. Growth breeds more demand, higher inflation, and higher interest rates. And, finally, growth creates the conditions for a downturn.

The way I see it, we are still in the growth phase. The pending federal stimulus packages are likely to prolong and accelerate this phase. So, although there are real concerns—medical and economic—that need to be watched, conditions remain favorable. As such, we should expect normal changes in the economic cycle, which is largely what we are now worrying about. But, because the cycle is now returning to normal, we can look back at previous cycles for guidance.

As we move out of the pandemic, at least from an economic and market perspective, we return to something like normal. As we do so, old strategies become new again. We know what to do, so now we can start doing it again.

This is the natural conclusion. If we are past the pandemic, we will be returning to normal. And when we do that, the normal rules for the economy and that market will reassert themselves. The environment has been different this time, due to the pandemic, but we are moving away from that. So, let’s think about how we invested before the pandemic and start applying those lessons once more.

Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.

Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held Registered Investment Adviser-broker/dealer. He is the primary spokesperson for Commonwealth’s investment divisions. He is also the author of Crash-Test Investing, a must-read primer for Main Street investors seeking to help insulate their portfolios against a market crash. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan. Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.

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