The Name Is Bond, Treasury Bond: Rising Yields Kill Stocks

The shrewd contrarians who read my daily Mind Over Markets column shouldn’t be surprised by today’s market decline. According to the conventional wisdom on Wall Street, robust corporate earnings were supposed to supersede all other worries. So when bond yields spiked today, the investment herd was easily spooked.

The main stock indices opened in the red Thursday and kept heading south throughout the trading session, closing in negative territory.

U.S. bond yields resumed their upward trajectory today, which rattled Wall Street. The 10-year Treasury bond yield climbed above 2.91%, a key level that it hasn’t been able to stay above several times this year.

Economic data today pointed to robust growth in manufacturing activity, suggesting that the economy could overheat, spark inflation and prompt the Federal Reserve to aggressively tighten. The analyst consensus is that the yield on the 10-year Treasury bond will top 3% this year, a bad omen for stocks.

The case for small caps…

Amid this anxious backdrop, analysts are increasingly bullish over small-capitalization stocks. Recent sharp declines and volatility among overvalued large-cap stocks highlight the wisdom of seeking small-cap stocks, which are poised to outperform in 2018.

After underperforming their larger counterparts for the past one- and three-year periods, small-caps and related exchange-traded funds (ETFs) are taking the lead.

The term “small cap” is fungible, but it’s generally a company with a market capitalization of between $300 million and $2 billion.

The recent stock market correction underscored the danger of investing in momentum stocks that are overvalued based on unrealistic earnings assumptions. In what’s shaping up to be a tough year ahead, small-cap companies could bring sanity to your portfolio.

As I’ve explained in recent columns, the large-cap market leaders are priced for perfection. That sets them up for failure. We’ve seen how bellwethers have gotten punished this quarter by delivering earnings that didn’t meet Wall Street’s lofty expectations.

Typically, small caps are considered riskier. However, bull runs often are propelled by a relatively small number of strong stocks that are “market leaders.” When these stocks begin to falter, it could mean that the rest of the troops will follow. We’ve seen this dynamic in recent weeks.

Washington, DC has embarked on an experiment that violates most norms of economic policy. Uncle Sam is applying massive stimulus in the late stage of a recovery. That makes overvalued large caps, especially those that have led the bull market in recent months, vulnerable to inflation and rising interest rates.

Small businesses represent more than 99.7% of all U.S. employers. They employ half of all private sector workers. They account for up to 80% of the new jobs created annually in the country. Every portfolio should have exposure to these dynamos. The second quarter of 2018 is a good time to start.

I’ve been warning you that the correction isn’t over. Mega-cap market leaders are poised to become laggards. Inflated expectations will catch up with them. However, several tailwinds position small stocks as safer havens for investors.

Let’s start with President Donald Trump’s policies, which are of surprising benefit for smaller companies.

Profitable firms in the Russell 2000 tend to pay higher taxes than global behemoths. The big boys are adept at lowering their rates through expensive lobbyists and accountants; they also avoid taxes by squirreling their profits overseas.

The tax overhaul bill that Trump signed in December includes numerous changes to the taxation of income from pass-through entities such as S corporations, limited-liability corporations and partnerships. In general, the new law allows businesses to exclude 20% of their net income from taxation, subject to certain limitations.

Overall the changes to the taxation of pass-through entities will be beneficial to many small business owners. That’s a big shot in the arm for the country’s entrepreneurs and innovators.

Another future advantage for small companies is the likelihood that Trump’s laissez-faire cabinet members and agency heads will lessen regulations against the financial services sector. That in turn will make it easier for regional banks to give loans to small companies.

Trump’s “America First” protectionist policies pose a threat to expert-dependent giants. Indeed, trade tensions between the U.S. and China continued to worsen this week. However, U.S.-based small caps are largely immune to these “headline risks.”

Most of these small caps derive the bulk of their sales domestically, which means that trade wars and a strong U.S. dollar tend to hurt them less. That’s something to consider, as investors get whipsawed by daily headlines. Let’s do the numbers.

Thursday Market Wrap

  • DJIA: -0.34% or -83.18 points to close at 24,664.89
  • S&P 500: -0.57% or -15.51 points to close at 2,693.13
  • Nasdaq: -0.78% or -57.18 points to close at 7,238.06

Thursday’s Big Gainers

  • ChannelAdvisor (NYSE: ECOM) +19.25%

E-commerce platform announces improvements.

  • American Express (NYSE: AXP) +7.66%

Credit card issuer beats on earnings.

  • Webster Financial (NYSE: WBS) +6.97%

Bank’s earnings excel.

Thursday’s Big Decliners

  • Aceto (NSDQ: ACET) -64.05%

Generic drug maker cuts dividend.

  • Paratek Pharmaceuticals (NSDQ: PRTK) -15.28%

Biotech issues debt offering.

  • Sleep Number (NSDQ: SNBR) -14.03%

Mattress maker reports weak operating results.

Letters to the Editor

“Do you expect the financial services sector to outperform this earnings season?” — Jonathan K.

Yes, I do. Bank stocks are enjoying several tailwinds. Higher interest rates boost the net interest spread that determines banks’ profit margins. Additional advantages now for banks include steady economic growth, rising energy prices and the tax cut bill.

But in the words of baseball legend Yogi Berra: “It’s tough to make predictions, especially about the future.”

Last Friday, three big banks delivered stellar first-quarter earnings results. JPMorgan Chase (NYSE: JPM), Citigroup (NYSE: C) and Wells Fargo (NYSE: WFC) all exceeded earnings and revenue expectations.

And yet, the shares of JPM, C and WFC dropped on Friday, as analysts found various faults in their operating results. Beware of unrealistic projections, especially in today’s unpredictable climate of headline risk.

Got questions about earnings season? I’m here to help:

John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.




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