It’s a question asked in a foreboding tone when markets behave a certain way: “What does the bond market know that the stock market doesn’t?”
The market behavior that prompts this query is a decline in Treasury yields coinciding with rising stock prices, and it’s what we’re seeing so far this year. The 10-year Treasury is near its 2019 low of 2.60 percent, while the S&P 500 is at its year-to-date high, up more than 12 percent.
The conceit of the question is that receding bond yields are a signal of slowing economic growth, rising financial risks and waning risk appetites.
If any combination of those forces is at work, then a steady climb in stock indexes would seem incongruous and perhaps ill-fated.
Yet there are reasons to doubt that there’s any inherent inconsistency or acute vulnerability to the market in the current trend of strong stocks and subdued yields.
For one thing, there’s nothing all that unusual about stock and bond prices rising together. (Yields move inversely to prices) It was the rule for most of the 1980s and ’90s. And this relationship played out over previous phases of the current economic cycle.
In 2014, the 10-year Treasury yield sank from 3 percent to 2.1 percent over the course of the year, and the S&P 500 gained more than 11 percent, posting new record highs. Likewise, over the course of 2017, when yields slanted lower as stocks had one of the gentlest ascents in memory, rising 20 percent with hardly any pullbacks.
Then there’s the fact that in recent months both stocks and bonds are pricing in a transparent and patient Federal Reserve, which is able to take this posture because inflation appears well-contained. This also is helping to compress volatility in both stocks and bonds, with the CBOE’s equity volatility index below 14 at a five-month low.
Taken together, slim bond yields, a gentle Fed and ebbing volatility tend to support or expand equity valuations, even with corporate profits seen going flat in the first half of the year.
Jim Paulsen, chief investment strategist at The Leuthold Group, points out that the markets are responding in concert to an economy coming off a scare over potential overheating and a possible Fed mistake.
“It is not that the bond market knows something the stock market doesn’t,” he argues. “Although Treasury yields often fall and remain lower at the start of a recession, they also frequently decline and remain lower when the valuation of stocks and bonds rise together. Rather than signaling a pending recession, recent action in the Treasury market more likely reflects the common aftermath of a mid-cycle overheat within an ongoing expansion.”
The kinds of stocks gaining favor also fit with a low-yield environment: dividend-rich utilities and real-estate investment trusts are near all-time highs. So is the S&P Invesco 500 Low Volatility ETF (SPLV), which contains more stable companies rather than cyclically geared ones.
And big growth stocks – those promising many years of expected rising cash flows to come – are leading again: The Russell 1000 growth index has outpaced its value counterpart by 1.5 percentage points in the past month. The 52-week high list from Wednesday speaks to this preference, featuring the likes of Mastercard, PayPal, Intuit and American Tower.
All this suggests that the market is not recklessly pricing in a big economic acceleration or earnings snapback that the bond market isn’t. Equities are mostly recovering the nasty downside overshoot of December while investor sentiment and positioning have gradually returned toward a more neutral state.
Low Treasury yields would be a bigger worry for stocks if the yield curve were flattening further, or if corporate bonds were being shunned.
The Treasury yield curve has been narrow but steady this year, between 0.15 and 0.2 percentage points between the 2- and 10-year maturities.
And the risk spreads on high-yield corporate debt have tightened up since December and are back toward November values, which is pretty consistent with the S&P 500 trading back up to early November levels.
All of this helps explain how stocks have managed to rally while yields trend lower. But it doesn’t answer the question of how long it can go on this way, or just how much further lift stocks can derive from a patient Fed and undemanding corporate-debt costs.
Back in the first half of 2016, with global yields remaining quite low and a similar mix of dividend-centric and growth stocks carrying the market higher, the S&P traded up to a forward price/earnings multiple above 17, until profit forecasts finally bottomed and growth expectations picked up.
Right now, the S&P 500 trades at 16.3-times forecast earnings for the next 12 months. The estimates for 2019 earnings are down a bit more than 7 percent since their October high, while the S&P 500 is off a bit more than 4 percent from its peak.
One could argue that stocks have already given companies credit for weathering this profit slowdown and resuming growth later this year, with most of the projected improvement slated for the fourth quarter.
At some point, soon or not, this could seem like an overly rosy outlook and perhaps then stocks would be on more fragile footing. But it won’t be because the bond market now “knows” anything that’s particularly scary.