In the last two weeks I have tried to ignore the back and forth of the financial markets of the world and instead separate my comments into two spaces; the volatility around when new Fed Chair Warsh made his first comments, and the bond markets of the world and more specifically the direction of interest rates. For the last couple of months, I have been warning of a very difficult market environment that was being expected going into the midterm elections and the first term of a new Fed Chair. As I had suspected, things have been difficult and frustrating. Earnings have basically been off the charts. This wasn’t a single quarter situation but rather a continuation of this acceleration that has been in place for the last six quarters.
Thomas Lee of FundStrat has been what I find to be the most accurate in his forecast of market movements, and he has been saying since the beginning of the year that he was looking for an advance to new highs in August and then a correction into the beginning of October and then a very strong finish to the year. I don’t know how he has been able to be as spot on as he has been, but I will continue to respect what he is saying while doing my own work until the music changes. What I find to have been the most accurate probability expectation has been the Presidential Election Cycle. This basically goes back in time and looks at every four-year term of a president and then gives the average expectation. This being the second year, or midterm year, it has historically been the most difficult. What needs to be remembered is that difficult can mean a tug-o-war sideways and not necessarily a swoon to the downside. Here is where we are. Note that the markets have been fitting pretty good with the expectation.
If things move true to form as postulated in the four-year cycle above, the next thing to focus on is where one could possibly want to be situated coming out of this turmoil time. Post-midterm year-end rallies tend to be led by growth stocks. I bring this up as the growth part of the markets have been lagging the slower growing value part of the markets. Since the broad markets have not shown decline but rather a back-and-forth kind of action since Mid-May, a major shift does not appear to be occurring but instead a respite for growth, an advance for value, and collectively a “churning” type of action up at the highs.
The value side of the equity markets have been lagging growth for a number of years. Therefore, it is important to consider whether this is a pause to refresh for the growth companies or a complete changing of the guard. Major leadership shifts usually require a cyclical bear market. If the bull is going to continue deep into 2027, as is the base case for most research platforms, then growth stocks should retake the leadership mantle after the consolidation phase ends.
The unwind of the hedge fund Situational Awareness in July left several mega-cap Growth stocks deeply oversold. Besides being oversold, they are also now trading at valuation levels that would tend to infer that their growth is done and that the party is over. I don’t believe this to be the case as AI is changing the landscape as other technology or industrial revolutions have. How this will play out I have no idea, but I find it fascinating that the press was completely Anti-AI and Anti-data center this past weekend. If this is what the press says, markets tend to do the opposite.
Bond market dilemma
Last week I focused on bonds. I did so as I could not find anything “different” in the earnings environment or the international situation to explain why markets could be having frictional times. Volatility has taken center stage in fixed income, challenging the old rules of steady income. As I explained last week, if credit spreads and overall interest rate moves remain contained things “should” be OK. Here is what we are seeing now:
Key Points
- Bond returns are no longer driven primarily by predictable coupon income, as price volatility has become a dominant force in shaping outcomes. This is visually apparent in the fact that rates are now eclipsing multi-decade high points, even though the moves are still not particularly large and definitely not sharp like the stock market moves have been.
- Rapid shifts in interest rates, inflation surprises, and changing risk premiumshave amplified market swings, making the return path far less stable than in the past. Again, these have not been seen as yet.
- In this environment, success may depend on adapting traditional fixed-income strategies to accommodate a more uncertain landscape. The only uncertainties seem to be non-related to the markets and are mostly geopolitical in nature.
For decades, fixed-income investors could count on steady coupon income as the primary source of return. But the last several years have rewritten that playbook. As the chart below shows, price movements—both positive and negative—have increasingly dominated the return experience for bonds. In fact, over the past decade, price gains accounted for an average of 55% of quarterly total return in quarters with positive price returns.
This is what has gone on since 2016 when looking at the two components of a bond; bond market value change + interest earned on the bond. Note that since the COVID debacle when the governments of the world helicopter dropped trillions and trillions of their currency on their population, interest rates have been rising. As rates rise, market value of bonds drop, and the total return is wiped away. As can be seen below, this has been the case more often than not since 2020.
Breaking Down Bond Returns: Coupons vs. Price Moves
Coupon returns are generally predictable because they’re calculated as a fixed percentage of the bond’s face value at the time of issuance. Price returns, on the other hand, reflect the market’s reaction to shifting interest rates, yield-curve dynamics, and changing risk premiums. Since the pandemic, inflation shocks and rapid Federal Reserve (Fed) policy shifts have amplified these effects, creating wide swings in quarterly price returns. For investors, that means the path of rates, not just the level, has become a critical driver of outcomes. This shift isn’t happening by chance. Inflation shocks, frequent Fed pivots, and shifting risk premiums have pushed interest-rate sensitivity to the forefront of fixed income. In this environment, with an uncertain path forward for interest-rate policy, price swings may overshadow the steady drip of income, making the old “buy and hold for yield” playbook less reliable.
Adapting to a More Volatile Bond Market
The takeaway isn’t that bonds have lost their value—it’s that fixed-income strategies need to adapt. Active management, stress-testing for rate volatility, and diversifying across sectors have become essential tools. Yield and price appreciation still matter in fixed income, but the road to those returns is far less predictable than it once was. For financial professionals and investors alike, understanding where returns come from, and the risks that come with them, has never been more important. Since there really isn’t a big bang for the buck to be had by extending maturities, we have chosen to stay in highest quality and shortest maturity instruments. The 30-year is paying a bit over 5%, and the short-term is paying around 4%, so I can’t find a reason to take on the risk of longer bonds for only 1% more interest. The risk is far greater than the additional 1% income.
This week’s note may appear to be particularly short, but this is intentional as there is really not much more to be said. I am focused on earnings, rates, oil & gold, and the international conflicts. Other than that, if nothing changes, nothing changes. My fear is that as we get closer to the midterm elections the media drum could start to beat very loudly around the idea of political opinions. The spectrum of opinion on social and political issues is one of the broadest I can recall. In the absence of anything concrete in the business arena, this could be the focus of the news media.
-Ken South, Tower 68 Financial Advisors, Newport Beach
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