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If we were to get this rotation, from tech/growth to value/financials, it could be rough for the broad stock indices, because after a decade of tech outperformance, these sorts of highly-valued tech names dominate the top slots of the index, whereas financial stocks and value stocks in general make up a smaller portion.

Lyn Alden

The stock market experienced some turbulence over the past couple weeks, but so far has managed to recover.

The S&P 500, which the C Fund tracks, had a bit of a dip but is back to all-time highs:

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Chart Source: YCharts

The inflation-protected area of the Treasury market appears to be factoring in a high probability of stimulus passing within this quarter, as it continues to push up inflation expectations to 7-year highs.

This chart shows 5-year inflation expectations in blue and official inflation rates in red (which come out with a bit of a lag):

Chart Source: St. Louis Fed

The rest of the bond market is getting dragged along slowly as well. 10-year Treasury rates are back up to highs not seen since March 2020 when the pandemic hit, while the Federal Reserve is keeping short-term interest rates at zero.

As a result, the yield curve (the 10-year Treasury yield minus the 3-month Treasury yield) is steepening, as it typically does in this stage of the economic cycle:

Chart Source: St. Louis Fed

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All else being equal, a steepening yield curve tends to be good for financial stocks, and not particularly good for high-growth tech stocks.

If this were to continue, and that’s a big “if”, then we should expect to see bank stocks such as US Bancorp, do reasonably well:

Chart Source: F.A.S.T. Graphs

And we could see highly-valued tech stocks like Apple start to consolidate or correct a bit:

Chart Source: F.A.S.T. Graphs

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In those F.A.S.T. Graph charts, the orange and blue lines represent company earnings at historically normal valuation levels (including two years of consensus analyst forward expectations), while the black line represents actual share price.

We can see that the bank stock, as part of an out-of-favor sector, has mostly followed along with earnings. On the other hand, people have piled into stocks like Apple at almost any price, since the yield curve was so flat and with a pandemic raging, they wanted to be heavily exposed to tech and less exposed towards cyclical stocks that are more exposed to the economic cycle.

If we were to get this rotation, from tech/growth to value/financials, it could be rough for the broad stock indices, because after a decade of tech outperformance, these sorts of highly-valued tech names dominate the top slots of the index, whereas financial stocks and value stocks in general make up a smaller portion.

It’s certainly a tough environment for investors. On one hand, interest rates are among the lowest they’ve ever been, and are below the prevailing inflation rate, so cash and Treasuries (including the G Fund) are slow-melting ice cubes in terms of purchasing power. On the other hand, many popular growth stocks are extremely expensive by most valuation metrics, which calls into question their forward return prospects as well.

International markets on average have more of a value tilt than US markets, which is part of why they have underperformed over the past decade. Having some exposure to the I Fund could potentially aid a portfolio if the yield curve continues to steepen.

In IRAs or other accounts, investors can target certain sectors, such as financials and industrials and commodity producers, which should theoretically do better in this environment going forward than some of the growth names, assuming the yield curve continues to steepen. However, active management like that is notoriously difficult for investors to pull off successfully.

Overall, maintaining diversification is the primary way to avoid major losses. US stocks, foreign stocks, a bit of cash/bonds, and perhaps some alternatives like emerging markets or commodities, can potentially help in this unique environment.

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Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.

TSP Investors Handbook, New 7th Edition