Stocks continued their rally on Thursday morning, a day after the Federal Reserve indicated that it would likely begin tapering bond purchases in November and conclude the program by mid-2022. It also suggested that it would raise interest rates next year in response to higher-than-expected inflation. On the employment front, the Labor Department said that first-time claims for state unemployment benefits rose to 351,000 for the week ended September 18, up from 335,000 a week earlier and above the consensus forecast of 320,000. The Dow rose 1.5%, the S&P 1.3%, and the Nasdaq 0.9%. Crude oil rose to nearly $73 per barrel, while gold traded near $1753 per ounce.

The Federal Reserve wrapped up its Open Market Committee meeting on Wednesday and, as expected, made no changes to its current accommodative stance. But change may be coming soon. Fed Chairman Powell commented that the central bank has met its goal of lifting inflation above its former 2.0% target, at least temporarily, and that it is 50%-60% toward its goal of restoring pre-COVID employment levels. Thus, at its next meeting in early November, the Fed may be in position to announce that it will slow the pace of the asset purchases that it has undertaken for the past 18 months in order to keep long-term rates low and credit markets functioning. Whether or not the Fed starts tapering at the November or December meeting, we expect the program to be wound down by mid-2022, leaving the Fed's balance sheet above the $8 trillion level. As for the Fed's other recession-fighting tool -- the currently low federal funds rate - Fed governors are now indicating that the first fed funds rate hike may occur in late 2022, depending, of course, on the state of the economy. The Fed's dot-plot forecasts call for as many as 6-7 fed funds rate hikes by the end of 2024.

The Market's Big Test

Sentiment remains quite optimistic based on current data, which is from last week. Still, we are pretty sure that this week's sentiment data will show that some investors have backed away from their enthusiasm about the stock market due to the rather large pickup in price volatility in recent days.

Our proprietary Treasury Bond Yield Model is signaling that bond yields, which have declined more than 40 basis since late March, are too low based on investment fundamentals. Our model takes into account factors such as current yields, GDP growth, and long-term inflation, as well as stock prices and earnings, in order to make an asset-allocation recommendation between stocks and bonds. We smooth trends over a five-year period to avoid short-term momentum swings. Our current 10-year T-bond fair value yield is 3.4%. The normal valuation range has a floor of 2.1% and a ceiling of 4.7%. The current 10-year bond yield is around 1.35%, below the low end of the fundamental range and about 60% below fair value. Why is this the case, especially given recent GDP growth and inflation trends, not to mention aggressive fiscal stimulus spending from Washington during the pandemic? In our view, the low U.S. yields more likely reflect technical factors such as heavy buying from overseas investors seeking safety (or at least, yields that are not below zero), rather than the economic fundamentals. From an asset-allocation standpoint, we think bonds remain fully valued compared to stocks and recommend that long-term investors modestly favor equity securities in their diversified portfolios.