July 20 marked the seventh all-time closing high for the S&P 500 this month. The Dow’s nine-day winning streak is its longest in more than three years. Meanwhile, the U.S. 10-year Treasury bond yield is not too far from its all-time low of 1.37 percent.
So how are stocks at record highs if bond yields are near record lows?
Low bond yields signal low inflation and poor macro fundamentals for stocks—weak economic growth. But also, U.S. bond yields have been dragged lower by negative rates in Europe and Asia. Bouts of U.S Treasury bond flight-to-safety buying, which lowers the yield, arise from uncertainty-creating events like Brexit.
The International Monetary Fund downgraded its global growth forecast on July 19 due to Brexit, which it calls an “important downside risk for the world economy.” The forecast was shaved by 0.1 percent to 3.1 percent for 2016 and 3.4 percent for 2017. The U.S. forecast was cut 0.2 percent to 2.2 percent for 2016 and left at 2.5 percent for 2017.
No Fear
The S&P 500 laughed off Brexit. Since the post-Brexit low on June 27, it’s up 8.6 percent.
Helping power stocks forward is an improving earnings outlook and higher valuation.
It’s relatively early in second-quarter earnings season, but after a dismal first quarter, earnings appear to have bottomed. And near-record-low bond yields have helped price-earnings (P/E) multiples expand.
As of July 20, RBC noted that about 23 percent of S&P 500 companies (by market capitalization) have reported earnings which are beating expectations by 6.5 percent.
FactSet noted that on Dec. 31, 2015, the trailing 12-month P/E was 17.9. As of July 15, it had grown to 19.4 due to the S&P 500’s rally and decrease in earnings.
“Stock valuations are going up mainly because global bond yields are going down and that creates an environment where there’s very little choice,” RBC Wealth Management’s Alan Robinson tells Epoch Times.
Investors searching for yield aren’t finding it in the bond market and the utilities and telecom sectors—yield proxies—have led the stock market higher.
Robinson’s call in early June has been a very good one. The S&P 500’s P/E multiple has expanded and the greater risk of a “melt-up” as opposed to a meltdown in stocks has taken place.
“We’re seeing this slow appreciation of the idea that we can ramp earnings multiples up even though the underlying earnings picture is still bottoming out,” Robinson says.
He says the stock market is validating the idea that the turbulence earlier this year is petering out.
The next part of the move, he says, is for earnings to pick up. Early signs of that are being seen so far in Q2. He thinks returns on stocks have “high single-digits potential upside” over the next year.
But there’s no question stocks are expensive. Goldman Sachs noted on July 15 that the median stock’s P/E in the S&P 500 is at the 99th percentile relative to the last 40 years. But the investment bank also says the valuation is justifiable only because of historically low interest rates.
But the difference in yield between the 10-year treasury bond and the S&P 500 of about 4.2 percent is not outrageous. In fact, it is “currently consistent with the past decade average,” according to Goldman Sachs.
Robinson believes the next potential catalyst for a leg up in stocks could come from government spending in Europe. Governments want to appease disaffected voters who aren’t seeing wage growth and are struggling with income inequality.
“They’re going to have to engage in some kind of fiscal stimulus,” says Robinson.
To use a notorious line, it’s “kicking the can down the road,” which keeps working as long as there are buyers of government debt, including central banks.
“Admittedly a large portion of the cases, it is central banks that are buying these sovereign bonds,” Robinson says. “But as long as we’re in that position, we have the conditions for further fiscal expansion even though debt loads would be increased.”
More Upside
Despite the run-up in stocks, the most bullish argument, in Goldman’s view, for further upside, is that stock allocations are still relatively light.
Money has actually moved out of U.S. equities so far in 2016. According to EPFR Global as of July 13, U.S. equity assets under management is 1.8 percent lower from the beginning of 2016.
Bank of America Merrill Lynch’s Fund Manager Survey shows investors are sitting on a mountain of cash—the most since 2001. Investors tend to keep high cash balances in times of uncertainty. The last couple of notable peaks for cash balances took place last summer as the Chinese currency devalued and in 2012 amid “Grexit” fears (Greece exiting the eurozone).
Robinson says the conditions are ripe for stocks to move higher as more money enters from the sidelines. A common theme he hears when speaking to mutual fund managers is their underexposure to stocks.
“They are worried about keeping up with their benchmarks, but particularly about having too much cash on the sidelines as we move to new highs,” Robinson says.
“Underinvestment won’t be as extreme this quarter as it was in the last.”
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