The equity markets rallied for the fourth week in a row last week with gains averaging 0.75%. Stocks continue to be supported by the bullish and uncommon combination of improving economic fundamentals and falling interest rates. The financial markets have also found support in a strong U.S. dollar. This combined with the fact that foreign sovereign bond yields are lower than U.S. Treasury 10-year and 30-year paper is helping to keep rates low at home.

European bond yields have plunged in recent months but have not assisted Europe’s economy that continues to struggle with persistently high unemployment and the threat of deflation. Despite negative interest rates, consumer prices rose 0.3%, well below the ECB’s target of 2.0%. The situation is similar in Japan and China as growth rates have stalled. As a result, foreign investors are attracted to U.S. bonds and stocks.

This helps explain the strong performance by the S&P 500 and NASDAQ in August. While domestic investors are nearly fully committed and hold the lowest cash reserves since 2007, foreign investors have compensated by increasing their demand for U.S. assets. This supports the likelihood that the path of least resistance will remain to the upside.

Although investors should anticipate a continued strong demand for U.S. securities, the stock market is not without risk. In addition to the rising level of geopolitical stress, Central Bank policies of zero percent interest rates means that global economies and financial markets are vulnerable to an outside shock. In previous examples, the markets could depend on the Fed to continue to lower interest rates until the threat passed.

The risks are also elevated by the fact that valuations are stretched and stocks are entering what historically has been the weakest two months of the year. The recommended strategy is for investors to maintain current asset allocation levels. Strong support using the S&P 500 is at the August lows of 1900. A break of that level would likely result in a more conservative allocation toward stocks.

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Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC. The opinions expressed are subject to change, are not a complete analysis of every material fact and the information is not guaranteed to be accurate. 

Evan R. Guido

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