Beware rising bond yields!
For over a decade, bears claimed puny interest rates were the sole reason stocks soared, saying investors had no viable alternative. They see global central banks’ rate hikes ending that. Fallout from failures at Credit Suisse and U.S. regional banks further fan those fears. But such thinking is folly. Interest rates don’t rule stocks. Here is why.
That higher bond yields stymie stocks presumes these two fight for some singular pile of funds. On one side: bond yields, like Canadian 10-year rates, which are currently yielding about 3 per cent. On the other: stocks’ earnings yield – the inverse of the price/earnings ratio, (the earnings return shareholders would get forever if earnings and price remain constant.) Conventional wisdom holds stocks’ earnings yield must reasonably exceed Treasury yields to be worth their volatility.
Nice theory. In reality, real, inflation-adjusted earnings grow over time with the economy. Businesses expand and innovate. But inflation also increases nominal earnings on top of gains in real earnings. En route, profits wiggle and waggle, plunge and soar. Business-cycle volatility makes earnings yields especially prone to skew around market lows and early in new bull markets, which is where I think we are now. Why? Stocks look forward, while earnings look backward. Analysts’ earnings projections always skew lower when the recent past stinks. That’s human nature. Look no further than the S&P 500′s flat EPS growth projection in 2023, and Canadian stocks’ negative 4.5-per-cent projection, as profits from energy stocks face tough comparisons with previous earnings. Early in bull markets, you get a lower “E” and higher “P,” briefly squishing earnings yields (and inflating most other valuation metrics).
Hence, spreads between stock and bond yields hold irregular predictive power. Take the bull market of the early-2000s: In the United States, the average gap between 10-year Treasuries and the S&P 500′s earnings yield using projected earnings was 2.23 percentage points through its entire stretch – near today’s much-feared 1.89-percentage-point spread. U.S. stocks didn’t mind. They rose 121 per cent in U.S. dollars.
High bond yields don’t thwart bull markets, either. Consider the United States in the 1980s and 1990s. During the entire two-decade stretch, 10-year U.S. Treasury yields topped 4 per cent. They were over 10 per cent for more than half of the 1980s. U.S. stocks still soared 400 per cent in the 80s and another 433 per cent in the 90s, in U.S. dollars.
In those two decades, Canadian 10-year yields averaged 11.5 per cent and 7.6 per cent, respectively, while Canadian stocks surged 197 per cent and 220 per cent.
How can stocks soar when “safer” bonds yield similarly, or more? Unlike bonds held to maturity, stock returns aren’t capped by coupon rates. They benefit from economic growth and innovation – with no ceiling. They also pay dividends. If management foresees earnings growth, they can borrow, buy back shares and retire them – soaking up supply while increasing earnings per share and juicing returns. That is happening now, largely unseen. Bonds can’t do any of that. And, if long interest rates rise further, the prices of existing bonds fall.
And so, what is the impact of inflation? Bond yields reflect inflation expectations. When yields are higher, inflation is likely elevated – as it is now – eroding coupon rates that are considered big. But companies can pass on cost pressures, so shares fare better with time. Yes, stocks sank as inflation soared last year, but this was mostly sentiment. Consider the fact that the gross profit margins of S&P 500 and Canadian companies ended 2022 at 33 per cent and 27.3 per cent, respectively, near 2021′s year-end 33.6 per cent and 26.5 per cent. Plus, the 2022 plunge in bond prices largely mirrored that of stocks.
Still, some say central bank hikes are the real threat, pointing to Canadian stocks’ decline after the Bank of Canada started raising rates last March. Canadian stocks bottomed out the same day as a rate hike in July, and have climbed since, despite four more hikes. The S&P 500 sits 1 per cent below levels prior to the Federal Reserve’s series of rate increases, rallying amid hikes since October. The shock is gone. The equity bears can’t see it.
None of this means interest rates don’t affect economies – they do. Or that earnings yield comparisons lack all utility. There is a time when they are valid, but rarely, and when few perceive it. For example, high bond yields plus unexpected earnings growth delivers an increase in earnings yields, especially if rates then fall unexpectedly. But rates don’t dictate stock direction. The proof? The correlation between Canadian stocks and 10-year bond yields is just 0.17 – frail, given 1.00 represents lockstep movement and minus-1.00 is the opposite. The S&P 500 has a similarly flimsy 0.24 correlation with 10-year Treasuries.
Despite this, large-scale rate fretting persists, showing sentiment is still snarkily pessimistic, as most observers hunt for negatives that are sure to stomp stocks. Such fixation on false fears is bullish – always.
Ken Fisher is founder, executive chairman and co-chief investment officer of Fisher Investments.
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