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Stocks Slip as Earnings Wrestle with Rates

Rising bond yields have been wrestling with strong earnings. Today, bond yields won.

Gains were easier last year, when the 10-year Treasury yield traded in its narrowest range in 50 years, inflation remained muted and volatility hovered at record lows. This year, profits will be more elusive. Rock-bottom interest rates, the underpinning of the post-crisis bull market, are disappearing amid rising inflation.

The main stock indices closed mixed today, as investors grappled with rising bond yields.  The Dow Jones Industrial Average and the tech-heavy Nasdaq both closed in the red; the S&P 500 inched into the green. Trading was choppy.

The closely watched 10-year Treasury bond yield hit 2.97% today, flirting with the psychologically fraught threshold of 3%. The U.S. dollar’s short-term strength continued; the greenback rallied to a seven-week high.

The 10-year Treasury yield hasn’t hit 3% since 2014. Over the past 12 months, it has risen nearly 34%.

Rising bond yields reflect expectations that economic growth will overheat and fuel inflation, which would compel the Federal Reserve to more aggressively hike interest rates. Corporate earnings are coming in strong, which should buttress equities over the short term. But rising bond yields signal long-term trouble ahead.

New signs that the economy is over-revving came on Monday.

The National Association of Realtors reported that existing home sales rose 1.1% to a seasonally adjusted annual rate of 5.60 million units in March. The market for previously owned homes accounts for about 90% of U.S. home sales. Existing home sales increased for a second consecutive month in March.

Also on Monday, IHS Markit reported that its flash U.S. manufacturing Purchasing Managers’ Index (PMI) rose to 56.5 in April from 55.5 and reached a three-and-a-half-year high. Readings over 50 indicate expansion.

American companies grew faster in April, especially manufacturers, in a reflection of a steadily expanding U.S. economy. But inflationary pressures increased as well.

The IHS Markit survey warned of accelerating inflation, as the cost of raw or partly finished materials this month climbed at the fastest pace in nearly five years. The new White House tariffs on steel and other Chinese goods were cited as major culprits for the rise in costs.

You’re probably feeling wistful about 2017. That was the Goldilocks year, when economic and financial conditions were “just right.” Well, brace yourself. Goldilocks is dead.

The weighing machine…

These worrisome developments are occurring during a strong earnings season. For the first quarter of 2018, with 17% of the companies in the S&P 500 reporting actual results, 80% of companies have reported a positive earnings per share (EPS) surprise and 72% have reported a positive revenue surprise.

As of April 20 data from the research firm FactSet, the expected year-over-year blended earnings growth rate for the S&P 500 is 18.3%. On March 31, the estimated earnings growth rate was 17.1%. It appears that high expectations are only getting higher.

If 18.3% turns out to be the actual growth rate, it will mark the highest earnings growth since the first quarter of 2011 at 19.5%.

According to the bipartisan Committee for a Responsible Federal Budget, the new tax overhaul package will push the federal deficit to over $1 trillion in 2019. The federal government must issue bonds to finance that deficit. Making such a large amount of bonds attractive to buyers will require higher yields.

Higher bond yields boost borrowing costs; economic growth and corporate profitability suffer. But higher yields also make bonds a more attractive alternative to riskier stocks — and they make excessive equity valuations harder to justify. This dynamic undermines the TINA (There Is No Alternative) rationale for stocks.

Investors increasingly worry that the massive tax cut bill, combined with the growing federal deficit, will stimulate the economy at precisely the wrong time — at the tail end of an economic recovery when the job market is tight. The GOP-driven tax cuts could prove a Pyrrhic victory, because they provide a short-term benefit at the expense of long-term economic stability.

As super investor Warren Buffett put it: “In the short term the market is a popularity contest; in the long term it is a weighing machine.” Wall Street is weighing the long-term risks of rising inflation and bond yields, against the immediate popularity of tax cuts. Hence today’s mixed close in stocks.

Monday Market Wrap

  • DJIA: -0.06% or -14.25 points to close at 24,448.69
  • S&P 500: +0.01% or +0.15 points to close at 2,670.29
  • Nasdaq: -0.25% or -17.52 points to close at 7,128.60

Monday’s Big Gainers

  • McDermott International (NYSE: MDR) +15.70%

Energy infrastructure firm eyes merger.

  • Nautilus (NYSE: NLS) +11.52%

Analysts bullish on consumer fitness retailer.

  • Pivotal Software (NYSE: PVTL) +9.73%

Cloud provider bounces in wake of IPO.

Monday’s Big Decliners

  • Prothena (NSDQ: PRTA) -68.78%

Biotech’s leading drug candidate fails key trial.

  • Akorn (NSDQ: AKRX) -33.76%

Biotech’s larger peer cancels merger plan.

  • Gridsum Holding (NSDQ: GSUM) -16.05%

Software firm investigated for investor fraud.

Letters to the Editor

The Tweeter-in-Chief…

How worried should I be that a tweet from President Trump could tank a stock that I own?” — Deb H.

I have four words of important advice for you: Don’t trade Trump’s tweets.

In the vernacular of the early 1900s, President Theodore Roosevelt’s famous description of the White House as a “bully” pulpit meant that the presidency was a superb platform to advance causes and ideas.

As reflected by Donald Trump’s use of the presidential pulpit, the word “bully” has taken on its more contemporary definition. And when the president decides to attack a company or industry, billions in market valuation can instantly vanish.

But keep this overriding fact in mind: stocks hit by Trump’s harsh tweets invariably bounce back, as investors regain their commonsense. Sure, headline risk remains a concern. But tune out the president’s tweets. He often reverses his stated position anyway, sometimes in a matter of hours. Save yourself from getting whipsawed.

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

 


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