While interest rates in the bond market are rising uninhibitedly, the stock market may be in a dead-cat bounce, or a «sucker-rally». Some market specialists do not trust the rally and declare equities «a lost cause». In terms of allocations, the traditional appeal of a 60-40 portfolio appears to make a comeback now that the ‘earnings yield spread’ between stocks and bonds is narrowing.
Even a dead cat bounces if it falls from a high enough height. According to strategists, this is now happening to the stock market. The recent gains show a «sucker-rally», said Peter Toogood, CIO of Embark Group, speaking on US broadcaster CNBC.
Toogood expects a pullback in US stocks now that the S&P 500 is up 14 percent from its October lows. The index has now been heading just above the 200-day moving average of 3,940 points, a key technical indicator, for a month.
Never before in history have new lows been reached after the index has traded above the average for a month, but the macro figures do point to an upcoming correction, according to Sri Kumar, founder of Sri-Kumar Global Strategies.
Anyone who believes the current rally is indicative of a resilient economy should revisit the October 2007 stock markets, said Kumar, who sees equities as «a lost cause» at the moment.
The S&P 500 reached an all-time high on 9 October 2007 when the index closed at 1,565.15. Five months later, the S&P 500 was down more than 50 percent due to what later came to be known as the Great Financial Crisis. The same could happen again now, said Kumar.
Inverted yield curve
The strategist believes inverted yield curves are a more reliable indicator of the actual state of the economy. An inverted yield curve is often followed by a recession within 12 to 18 months.
A logical but important consequence of an inverted yield curve is the brake on commercial lending by banks, said Kumar. “Commercial banks borrow in the short market, and then lend that money to consumers for the long term. If banks have to pay more for their loans than the consumers they serve, there is no more incentive to lend.”
Both the ECB and the Fed are already detecting tighter standards for loans to businesses and households by commercial banks, and reduced demand. That, according to Kumar, is braking the economy harder than stock markets are pricing in.
Powell
Meanwhile, the rise in bond yields is still in full swing. While lending money to the US treasury for six months is already yielding 5.2 percent, Fed chairman Jerome Powell, speaking at the US Senate earlier this week, defended additional, rapid interest rate hikes. According to Powell, the economy shows too few signs of slowing down for interest rates to fluctuate between the current 4.5 percent and 4.75 percent.
This was not welcomed by all. Senator Warren of Massachusetts felt that Powel was playing with “human lives” if the Fed kept interest rates high for much longer.
“History clearly shows that the Fed has a terribly bad record when it comes to keeping unemployment increases in check, as a result of higher interest rates,” Warren said, calling on Powell to explain his policy himself to the two million Americans who may lose their jobs.
For investors, on the other hand, rising interest rates need not be problematic at all, Kumar said. “There are now equity returns to be had in the bond market at negligible risk.” According to data from research firm Refinitiv, the yield differential between the S&P500 and government bonds has not been this small since 2004.
Equity-bond yield spread narrows
At the end of February, the S&P 500 delivered an earnings yield of 5.41 percent, while the yield on the benchmark US 10-year bond rose to 3.96 percent on Wednesday.
The earnings yield - the inverse of the P/E ratio - is a measure of a company’s profitability relative to its share price and can be used to compare equities to other investment opportunities, such as bonds. The difference of 1.47 percentage points is the lowest return that equities have delivered relative to bonds in almost two decades, according to Refinitiv.
Luc Aben, economist at Van Lanschot Kempen, said equity traders are partly calling the negative commentary on equity markets on themselves. “When the chairman of the Atlanta Fed says that interest rates still need to go much higher and will stay there for a long time, investors react with disappointment. When the same Fed chief nuances his statements the following day by stating that a pause in raising interest rates could be made this summer, equities immediately go up again,” he wrote in a market commentary earlier this week.
However, the “proof of the inflationary pudding is in the eating”, Aben said. In the services sector in particular, he said, price pressures need to systematically come down before we can “see any prospect of the end of increasingly tight monetary policy”.
Until that happens, equity markets risk making the same mistake as they did in summer 2022, the economist said. Then prices ran up because investors did not take the further upward interest rate path seriously enough. “In short, still remain cautious for a while.”
A Dutch version of this article can be read on InvestmentOfficer.nl.