Why higher bond rates do not dictate stock performance

Sentiment remains 'snarkily' pessimistic, as most observers hunt for negatives to stomp on equities

For more than a decade, market bears claimed ultra-low interest rates were the only reason stocks did well. They see recent central bank rate hikes ending all that. AFP
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Fact: Interest rates don’t 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 hikes ending all that.

Credit Suisse and the US regional bank fallout further fans 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, like long-term US Treasuries. 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 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, 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 2023 earnings per share growth projection.

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 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-ppt spread.

US stocks didn’t mind. They rose 121 per cent.

Even starker, in the late 1990s — from 1997 to 1999 — 10-year Treasuries exceeded the S&P 500 earnings yield on 88 per cent of days. Yet the S&P 500 soared 108 per cent.

High absolute bond yields don’t 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 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 aren’t 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 can’t 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 likely elevated — like now — eating away at seemingly big coupon rates.

But companies can pass on cost pressures — so shares fare better with time.

Yes, 2022’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 2022 at 32.8 per cent and 29.3 per cent, respectively — near 2021’s year-end 33.2 per cent and 29.9 per cent. Plus, bond prices’ 2022 plunge largely mirrored that of stocks.

Consider recent history. From January 2022, stocks fell. Since most of the central bank interest 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 all-time highs (in local currency).

Unlike bonds held to maturity, stock returns aren’t capped by coupon rates. They benefit from economic growth and innovation
Ken Fisher, founder, executive chairman and co-chief investment officer of Fisher Investments

Yet, the rate fear continues. You see that in the ubiquitous concern with bank failure risk.

None of this means interest rates don’t impact economies. They do. Or that earnings yield comparisons lack all utility.

There is a time they are valid — as with most market myths, lore and conventional market wisdom.

But earnings yields are mostly useful at rare times few perceive.

For example, high bond yields plus unexpected earnings growth delivers positive surprises, especially if rates then fall unexpectedly.

But there is a very long history of rates and stocks prices and it is easy to say the directional correlation between the two is very low, not strong.

Rates don’t 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.

Ken Fisher is the founder, executive chairman and co-chief investment officer of Fisher Investments, a global investment adviser with $160 billion of assets under management

Updated: April 06, 2023, 7:24 AM