The rally that shifted into high gear after the election extended through the second quarter. The S&P 500 gained 3% during the period to leave the index 9% higher for the year. This is the broad market’s best first half since 2013. Mega-cap technology stocks like Apple, Amazon, Facebook, and Netflix powered the NASDAQ index to its best start since 2009, gaining 14%.

Bonds also rallied (yields fell) despite the Federal Reserve’s two rate hikes so far in 2017. Both increases were measured and in keeping with the Fed’s plan to gradually remove the exceptionally easy monetary policy stance that has been in place for nearly a decade.

If the Fed is in tightening mode and stocks are rallying, why then are yields falling? Are stocks and bonds telling conflicting stories about future growth?  First, let’s look at what’s driving stocks: profits. Consensus estimates are for 15% growth in operating earnings this year and 13% growth in 2018 over 2017. Even if projections are tempered marginally, it seems reasonable that stocks would rally in advance of strong support from underlying earnings. The question then becomes valuation. At almost 21 times trailing 12-month earnings, stocks don’t appear cheap. Performing the same valuation calculation using forward-looking 12-month estimates (for the four quarters ending June 30, 2018), the P/E is a more moderate 17.7 times earnings, much closer to the long-term historical average of 15-16. Regardless, the level of “expensiveness” or “inexpensiveness” must be calculated using other factors such as interest rates. Today’s very low rates are also supportive of generally above-average stock valuations. In fact, one could argue that valuations should be even higher but for the fact that investors realize the Fed is likely to continue normalizing monetary policy with additional hikes.

Economic fundamentals are also supportive of rising stock prices. In addition to record high corporate profitability, other data are also showing strength. The headline unemployment rate (4.4%) is essentially at a 16-year low. The broader U-6 measure of unemployment may be a more accurate gauge, but it too is at similarly low levels. Housing construction remains robust as builders play catch up after years of underinvestment following the crisis. Globally, the Chinese economy grew 6.9% in the most recent quarter which exceeded expectations, and Europe seems to be improving despite Brexit anxiety.

Are bonds wrong?  Not necessarily. Inflation is trending below the Fed’s ideal range and shows few signs of accelerating. We might finally be nearing the inflection point where tightness in the labor market leads to wage inflation and an uptick in the overall rate of inflation, but the data are not signaling this quite yet. And just as “high” is a relative term – as in “stocks are high” – “low” is similarly relative. We talk a lot about the “lowness” of bond yields, and in a historical context they are very low. However, relative to other major sovereign bonds, a 2.35% yield on the 10-year U.S. Treasury seems juicy. For example, German 10-year “Bunds” are yielding 0.58% and Japanese 10-year bonds yield just 0.07%.

Although it seems like stocks and bonds are discounting two very different future outcomes, it is possible that the recent actions of both are appropriate given the current backdrop. Longer term, we believe that the strong underlying economy and Fed’s willingness to normalize interest rates will validate stocks’ rally and eventually force bond yields higher (bonds fall in this scenario). Whether stocks can continue rising alongside higher bond yields will depend on whether inflation remains under control. Hyperinflation would be negative for both asset classes.