JPM Has Truly Low Expectations For This Corner Of The Market

As we get ready to wrap up 2019, J.P. Morgan has released a note warning investors to expect low returns in the bond market next year.

After 10 years of low rates, this isn’t really a surprise. But it comes after a good year for bonds… and it comes as investors face important decisions about their portfolios.

I think all of this could end up being bullish for the stock market. Here’s why…

Going into the end of the year, long-term Treasuries have delivered a total return of 8%. That’s the best return since 2011, when bonds gained a total of 9.8%. Both years are highlighted in the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT) chart below, which shows total returns (gains from both interest payments and price appreciation).

For comparison, I’ve also highlighted two other years (2014 and 2016) to show other strong uptrends in the bond markets since 2010. The 2014 gains were part of a longer bull market. By the end of 2014, long-term investors were back to the level of wealth they had in 2012. In 2016, gains for that year were quickly reversed, and investors ended the year about where they started.

Annual gains are important in the bond market because many investors review their portfolios and make decisions about the next year at that time.

Many investors allocate a portion of their portfolio to bonds in order to dampen the volatility associated with the stock market. One popular approach is to allocate 40% to bonds and the rest of the portfolio to stocks. At the end of the year, they review gains and decide what needs to be sold and reallocated.

But this end-of-the-year practice isn’t just exclusive to individual investors; professional investment managers also complete this process. That means individuals with $10,000 portfolios and pension fund managers with trillions of dollars in assets are all facing the same decision of how to reallocate their portfolios.

After a good year in bonds — like the one we’ve just had — many investors choose to take profits and move money into stocks. This is especially true when the outlook for bonds is bearish, as it is right now.

J.P. Morgan’s Dire Outlook

Which brings us back to that J.P. Morgan research report I mentioned at the top. As part of their analysis, the firm’s researchers noted that investors in long-term government bonds shouldn’t get used to the type of above-average performance they enjoyed this year.

The analysts also expect the Fed to cut rates one more time in the second quarter of next year, with the interest rate on the 10-year Treasury rising to about 2.05% from about 1.75% today.

The reason these analysts expect rates to remain low? According to Barron’s, there will be “a deterioration in U.S. business confidence that may persist even if the U.S. reaches a trade deal with China.”

American businesses’ profitability has been declining since 2015, which means the drivers of the slowdown are deeper and more persistent than tariffs, the strategists wrote.

“We do not expect business sentiment to fully rebound,” the strategists wrote in their year-ahead outlook note. “Thus, we see below-trend growth persisting into early 2020.”

With this outlook, many investors may decide to hold the minimum amount of their portfolio in bonds. Additionally, many funds have allocation requirements (e.g., “bonds must account for 38% to 42% of the fund’s holdings”) that must be met at the start of every year. Because bonds have climbed so much over the past 12 months, they now likely account for a much larger proportion of holdings than when they started the year. That means, even if the outlook for bonds were bullish, professional fund managers would still have to dump a portion of their holdings.

Why This Matters

That means it’s pretty much guaranteed that going into 2020 we will see aggressive reductions in bonds and increases in the amount allocated to stocks.

That could explain why stocks had such a good year in 2012, which also followed a strong year for bonds.

All this bodes well for 2020.

That said, my Profit Amplifier Momentum (PAM) indicator turned bearish on the SPDR Dow Jones Industrial Average ETF (NYSE: DIA). So a pullback remains likely, however, I expect it to be shallow.

I expect buyers to appear on dips. A dip to $277 could be enough to bring buyers off the sidelines. It could also be a level where large investors begin adding to stocks to increase their allocations for the next year.

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