Notion that bond rates dictate stock performance largely unfounded

Interest rates do not really rule stocks. Here is why. For more than a decade, bears claimed ultra-low interest rates were the only reason stocks did well – giving them no real alternative. They see recent central bank rate increases ending all that.

The Credit Suisse crisis and the US regional bank fallout further fan those fears. But that thinking is very wrong. The notion that higher bond yields stymie stocks presumes these two fight for some singular pile of funds.

On one side: bond yields, such as long-term US Treasuries. On the other: stocks’ “earnings yield” – the inverse of the price/ earnings ratio, the earnings return shareholders would receive forever if earnings and price remain constant. Conventional wisdom holds stocks’ earnings yield must nicely exceed Treasury yields to be worth the volatility risks.

Nice theory. In reality, real inflation-adjusted earnings grow over time with the economy.

Businesses expand, innovate, create new products, new efficiencies. But also, inflation grows nominal earnings on top of real earnings. En route, profits wiggle and waggle, plunge and soar. Business cycle volatility makes earnings yields prone to skew around market lows and early in new bull markets – 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. Look no further than the S&P 500’s current 2 per cent earnings per share growth projection for this year.

Early in bull markets, you get a lower “E” and higher “P” – briefly squishing earnings yields. Hence, spreads between stock and bond yields hold irregular predictive power.

Take the US 2002-2007 bull market. The average gap between 10-year Treasuries and the S&P 500’s earnings yield using projected earnings was 2.23 percentage points through that entire stretch – a rounding error from today’s much-feared 2.16-percentage point spread. US stocks did not mind. They rose 121 per cent.

High absolute bond yields do not thwart bull markets, either. Consider the US of the 1980s and 1990s. Ten-year US Treasury yields topped 4 per cent in the entire two-decade stretch. They were more than 10 per cent through more than half of the 1980s. None of that stopped US stocks from soaring by 400 per cent in the 1980s and another 433 per cent in the 1990s.

How can stocks soar when “safer” bonds yield similarly – or more? Unlike bonds held to maturity, stock returns are not capped by coupon rates. They benefit from economic growth and innovation – without an upward bound. They also pay dividends. If management foresees earnings growth, they can borrow money, buy back shares and retire them – soaking up supply while also increasing earnings per share, juicing returns. That is happening now, largely unseen.

Bonds cannot do any of that. And if long rates rise further, bond prices, by definition, fall. Inflation’s impact? Bond yields reflect inflation expectations. When yields are higher, inflation is probably elevated – as is the case now – eating away at seemingly big coupon rates. But companies can pass on cost pressures so that shares fare better with time. Last year’s stocks sank as inflation soared. The rise of stocks comes with a lag, usually.

But consider this: The S&P 500 and world companies’ gross profit margins ended last year at 32.8 per cent and 29.3 per cent, respectively – near 33.2 per cent and 29.9 per cent at the end of 2021. Plus, last year’s plunge in bond prices largely mirrored that of stocks.

Consider recent history. From January 2022, shares fell. Since most of the central bank rate increases started last May, stocks fell for another four months. They have been up for six months since – through the bulk of the rise and its highest rates. The UK, France, Italy and Spain have all hit very recent stock market highs (in local currency). Yet, the rate fear continues. You see that in the concern with bank failure risk.

None of this means interest rates do not affect economies. Or that earnings yield comparisons lack all utility. There is a time they are valid. But earnings yields are mostly useful at rare times few perceive.

Rates do not rule stock direction. Yet, large-scale fretting over them does now – it shows sentiment remains snarkily pessimistic, as most observers hunt for negatives, waiting for other steel-toed boots to stomp on stocks.

Fixation on false fears is bullish – always and everywhere.

While rates do not decide share performance, the lingering concerns show that sentiment remains snarkily pessimistic