Rising Bond Yields: Good or Bad For Stocks?

Most retail investors obsess over the major stock indices. But right now, Wall Street is fixated on another equally important benchmark: the yield on the 10-year U.S. Treasury note.

This yield is used to help set the price of money for everything from mortgage rates to corporate borrowing. That makes its movement (the yield rises as Treasury prices fall) hugely consequential for the broader market.

Yields have been rising and for stocks that’s a mixed bag. But overall, the stock market rally hasn’t been derailed.

On Monday, the Dow Jones Industrial Average and the S&P 500 both closed at fresh record highs, rising 64.13 points (+0.18%) and 21.58 points (+0.47%), respectively. The tech-heavy NASDAQ rose 136.51 points (+0.90%), and the small-cap Russell 2000 rose 21.37 points (0.93%).

In pre-market futures trading Tuesday, the four main U.S. stock indices were poised to open sharply higher.

Read This Story: Don’t Fight The Bull

The action in the Treasury market is largely driven by U.S. Federal Reserve policy, inflation expectations, and the pace of government borrowing.

The Fed is on the verge of tapering its asset purchases and unwinding its $8.4 trillion balance sheet. Inflation is perking up amid supply chain disruptions and rising energy prices.

The 10-year Treasury yield currently hovers at 1.62%. The yield has been rising in recent months amid a more hawkish Federal Reserve and signs that inflation may prove “stickier” than expected.

Since the 1970s, there have been about 11 rising yield cycles. Contrary to conventional wisdom, these periods were favorable for the stock market. U.S. stocks generated a positive total return in nine of these cycles, with an annualized average performance of 13.4%.

Rising yields do pose a threat to momentum stocks (e.g. in the technology sector) as investors fret about the erosion of long-term cash flows for these companies. Higher rates mean future profits are worth less today. But rising rates lift other sectors.

Banks and insurance companies benefit because higher rates expand their profit margins. And because rising rates point to a strengthening economy, cyclical sectors such as consumer goods and industrials also benefit.

Earnings season: a tailwind for equities…

Fed tapering indicates the economic recovery is on solid footing, as underscored by robust corporate earnings performance this year.

As of this writing Tuesday, the blended year-over-year earnings per share (EPS) growth rate for the S&P 500 for the third quarter is 32.7%, according to FactSet. That’s substantially higher than the earnings growth rate of 27.5% that was expected at the end of Q3 on September 30. “Blended” combines actual results for companies that have reported and estimated results for companies that have yet to report (see chart).

So far, we’re getting a preponderance of positive earnings surprises from companies in the information technology, health care, financials, and communication services sectors.

Among the 119 companies in the S&P 500 that have reported earnings to date for Q3, 83.2% have reported above analyst expectations and 12.6% have reported below analyst expectations. Since 1994, in a typical quarter, 66% of companies beat estimates and 20% miss estimates.

The bull probably has enough juice to continue into next year. The consensus of analysts calls for year-over-year earnings growth of more than 20% for Q4 2021 and more than 40% for calendar year 2021. But with the indices at record highs, it’s getting harder to find appealing valuations.

Everyone likes a bargain. However, it’s often difficult for investors to buy otherwise fundamentally sound stocks when they finally hit the bargain bin. That’s because the circumstances that typically lead to bargain prices sow fear. And that causes investors to second-guess their strategy, even when their favorite stocks are selling at dream prices.

How can you discern the value plays from the value traps? Consider the advice of my colleague, Dr. Stephen Leeb.

Dr. Leeb just pinpointed a $128 trillion megatrend that’s poised to make early investors rich. After painstaking research, he has unearthed the reasonably valued stocks that are set to benefit the most. To learn more, click here.

John Persinos is the editorial director of Investing Daily. Subscribe to his video channel.