Market Optimism Masks a Deeper Concern
The stock market has been on a tear since Donald Trump’s election victory, with the S&P 500 surging over 4% to reach an all-time record close. However, beneath the surface of this optimism lies a more pressing issue: the sudden and significant rise in interest rates.
A Shift in the Winds
On November 18, the 10-year treasury bond yield jumped to 4.47%, a staggering 73 basis point increase in just over six weeks. This rapid shift has sent a clear message that contradicts the market’s euphoria. The rise in interest rates is driven by two factors: the “inflation premium” and the “real yield.” Both components spell trouble for stocks.
The Inflation Premium: A Warning Sign
The “inflation premium” measures investors’ expectations for average yearly increases in the CPI over the next decade. This component has risen from 2.19% to 2.33% since October, indicating that investors are concerned about the Fed’s ability to control inflation. This could lead to higher short-term rates, which would be detrimental to equities.
The Real Yield: A Darker Warning
The “real yield” has increased even more dramatically, from 1.56% to 2.15%, accounting for 59 basis points of the total rise. This is a critical indicator, as it exercises a gravitational pull over equity valuations. The higher the discount rate, the lower the value of future earnings, and hence the less investors should be willing to pay for stocks.
The Math Doesn’t Add Up
Despite the rise in interest rates, the market has continued to rally. However, this defies the fundamental principles of financial analysis. With a PE ratio of 29.4 on the S&P 500, stocks are priced at historic highs. The expected return on equities is a meager 3.4%, barely above the expected real return on the 10-year treasury bond. This narrow margin makes stocks a riskier and less attractive option.
Earnings Stagnation
The bulls argue that an explosion in earnings will keep propelling the markets. However, the math tells a different story. Profits have stagnated since 2016, with EPS rising only 2% overall in the past 11 quarters. This sluggish growth trails inflation by a wide margin.
A Structural Shift?
The leap in the real rate may represent a structural shift in the market, driven by concerns over gigantic budget deficits exceeding 6% of GDP. If this trend continues, it could spell trouble for equities. The safest part of the market, U.S. treasuries, is now offering stiff competition to stocks.
Hope vs. Math
The market’s optimism is driven by hope, but it’s the math that will ultimately prevail. Warren Buffett’s recent move to lighten up on equities and buy U.S. government bonds may be a sign that he’s aware of the shifting landscape. As the old adage goes, “hope is not a strategy.” It’s time to take a closer look at the numbers and adjust our expectations accordingly.
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