By David Nelson, CFA CMT
As the vaccine rollout continues investors will start to look beyond the Covid recovery and start to ask themselves some tough questions. The usual suspects or rogue’s gallery of market worries includes high valuations, rising yields, high unemployment and of course my personal favorite a geopolitical backdrop that challenges U.S. interests at every turn. Despite these misgivings and a week that knocked -2.4% off the S&P 500 and close to -5% off the Tech heavy Nasdaq most trend lines are still intact. The major indices are holding at or just below the 50-day moving average.
The bull case is easy to understand. Stock valuations don’t live in a vacuum and with the risk-free rate close to zero and a 10-year at or below 1.5% stocks still look like the better asset class. Of course, therein lies the problem. The recent rise in yields all along the curve has spooked the market in particular investors hiding in long duration equities like FAANG – Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) & Google (GOOGL). Large cap secular growth with its steady cash flows had become the fixed income alternative so it stands to reason that higher rates would challenge that leadership.
What drives the concern? Is it the absolute level of rates or the velocity of the move higher? Let’s dive into the data and find out.
Turn it Upside Down
I’m not going to re-invent the wheel. Goldman’s David Kostin has already done the heavy lifting in a recent note. Let’s piggyback on some of the work he and his team have done and find some answers.
Let’s start off by turning the data upside down. Instead of looking at traditional P/E ratios or (Price/Earnings) let’s take the current forward estimate of earnings for the S&P 500, $172 and divide by the S&P 500 index price of 3811. By my math the current forward earnings yield is 4.51% or 310 basis points above the current 10-year rate of 1.41%
Goldman’s David Kostin tells us that the 10-year would have to climb to at least 2.1% to reach the historical median of a 250-basis point spread between earnings yield and 10-year rates. That’s not a guarantee stocks won’t fall at a 300 bp spread but at least gives us a point of reference. Add the fact that earnings estimates have climbed every month since May along with a vaccine rollout that continues to gain momentum and the glass starts to morph from half empty to half full. Johnson & Johnson’s (JNJ) vaccine received approval Sunday as a single dose alternative for those 18 & older. Yours truly is receiving his first Pfizer dose Monday morning.
Given the above why have some investors started to head for the exits. It’s the velocity of the move that has driven the selling in both fixed income and equity markets. The genie is out of the bottle and for the moment all the rhetoric from Jay Powell and company hasn’t been enough to push her back in. Before falling back on Friday 10-year rates had jumped over 1 full percentage point doubling August lows and since the vaccine announcement in early November has continued to pick up steam.
Equity investors may be looking at rising yields, but bond investors are looking at falling prices. iShares 20-year Treasury ETF (TLT) is off over -16% since the peak and over -10% just this year. Selling begets selling as bonds enter their own bear market forcing everyone into short duration paper. Nancy Davis founder of Quadratic Interest Rate Volatility ETF (IVOL) says it best. Short is the wrong term. These funds are just less long.
We can see the damage all across the yield curve and while the Fed continues to hold down the front end of the curve 30-year yields have crossed above where they were a year ago.
David Kostin is correct in his analysis that given the current yield spread and the fact that 10-year paper would have to climb to over 2% just to hit the median stocks still remain the better asset class.
If the expected rise in yields can take place at a more measured pace stocks will be just fine. If, however the velocity of the move increases speed expect a few accidents along the way.
*At the time of this article some funds managed by David were long IVOL