Stock Prices Haven't Been Hammered by Rising Bond Yields. Here’s What Analysts Say.

Since October 2022, the astonishing performance of U.S. stocks has bewildered investors, raising numerous inquiries but offering few conclusive answers.

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One of the primary quandaries revolves around the remarkable ascent of stocks amidst the backdrop of soaring interest rates, which have reached their highest levels in over two decades, and bond yields, which are hovering near pre-global financial crisis peaks.

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In an unexpected turn, the recent surge in Treasury yields has resulted in the diminishment of the equity risk premium—the gauge of the additional risk investors undertake when opting for stocks over comparatively secure Treasury bonds—to its lowest point in nearly 22 years, as per data from Dow Jones Market Data.

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This counterintuitive trend contradicts conventional investment wisdom, which suggests that escalating bond yields should curtail equity valuations. Nonetheless, stocks are presently trading at a premium to projected earnings that exceeds the averages of the past five and ten years—periods characterized by significantly lower interest rates than those prevailing today.

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Nicholas Colas, co-founder at DataTrek Research, endeavored to shed light on this apparent disparity in a communication with MarketWatch. Colas suggested that investors might be either banking on the notion that corporate earnings are now more resilient compared to the 2010s, thus averting the typical 20% to 30% decline from peak levels usually seen during recessions, or they may be skeptical about the sustainability of current Treasury yields, anticipating a shift from their current levels.

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It is conceivable, Colas added, that the situation could be a combination of both factors. Regardless of the rationale, valuations of large-cap U.S. stocks signal investor anticipation of robust profit growth in the forthcoming years.

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Although this outlook may materialize, short-term expectations among Wall Street analysts concerning corporate earnings growth remain varied. A recent analysis by equity strategists at Goldman Sachs indicates that while the ten largest U.S. stocks are projected to witness a 32% increase in earnings per share in 2024, the remaining 490 companies in the S&P 500 index are expected to see a 4% decline in earnings.

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Despite the uneven forecasts for corporate earnings, the market rally has broadened in 2024. Since the beginning of the year, the number of S&P 500 sectors outperforming the index has expanded from three in 2023 to five as of Tuesday's close, according to FactSet data.

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Phillip Colmar, global strategist with MRB Partners, attributes this to the continued surprising strength of the U.S. economy, which has surpassed even the expectations of bullish investors. Consequently, investor expectations have shifted from anticipating a "soft landing" for the U.S. economy to envisioning a scenario of sustained expansion, despite the Federal Reserve maintaining its benchmark interest rate at its highest level in over two decades. This shift has favored more cyclical sectors of the market, despite subdued earnings forecasts from Wall Street.

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Colmar pointed out that economic data consistently surpasses expectations, with manufacturing and services sectors showing strength alongside a resurgence in housing activity, even amidst interest rate sensitivity.

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Further buoying investor sentiment are the Federal Reserve's indications of potential interest rate cuts later in the year, strengthening the bullish outlook.

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Although recent rises in Treasury yields have induced some weakness in major indexes like the S&P 500 and the Dow Jones Industrial Average, stocks have shown resilience compared to the turbulence observed when the 10-year Treasury yield briefly exceeded 5% in October. However, Colmar cautioned that stocks could become volatile again if yields surpass previous peaks and venture into uncharted territory.

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As of Tuesday, the S&P 500 closed at 5,209 points, marking a 45% increase from its October 2022 low, while the Dow closed slightly down and the Nasdaq Composite ended higher. The yield on the 10-year Treasury note also decreased slightly on Tuesday.

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