2023-08-07 11:55:43 ET
Summary
- The summer rally in the stock market is fading, and a cyclical bear market is expected to resume.
- Higher long-term interest rates and lower long-term interest rates are both negative for the stock market from this point on - it's a checkmate situation.
- The S&P 500 is still up YTD, but a significant valuation contraction is likely if 10Y yields sustainably rise above 4%, or sustainably fall below 4%.
The checkmate situation
The summer rally, which some call a new "bull market", is fading and the cyclical bear market is set to resume.
Specifically, further economic strength would likely cause an increase in long-term interest rates, or a bear steepening of the yield curve. This is a situation where long-term rates increase faster than short-term interest rates, due to an increase in long-term inflationary expectations, real interest rates, or both. The increase in inflationary expectations requires the Fed to further increase the short-term interest rates.
The stock market can digest a certain level of long-term interest rates, and also a certain level of short-term interest rates. However, it seems like currently, the stock market sees the 4% yield on 10Y Treasury Bonds as the red line. In fact, the summer rally peaked as the yield on 10Y Treasuries decisively crossed the 4% level.
Specifically, the current macro environment favors an increase in long-term interest rates for the following reasons:
- The Bank of Japan has started to exit the extraordinary monetary policy easing, and the decision to allow the 10Y JGB yield to reach the 1% level is likely to cause higher long-term interest rates in the US as Japanese investors sell US Treasuries to buy domestic bonds. Japan is the biggest holder of US Treasury Bonds, so this is a significant variable for future demand for US Treasuries, and the current market supply.
- The Fed is still implementing the quantitative tightening QT, or the reduction of balance sheet, which also increases the market supply of Treasury Bonds, and reduces demand. The QT is designed to increase real interest rates. The Fed is expected to reduce balance sheet until 2025.
- US inflation is likely set to increase again (as the base effects expire) induced by the higher wages, the spikes in commodity prices, and the general pressures caused by the unfolding de-globalization. Furthermore, President Biden's push to increase manufacturing spending is boosting the US economy at a time where such "boost" is actually a negative as it pushes inflation higher, and works against the Fed's efforts to cool off the demand.
- The US government is set to significantly increase the supply of US Treasury Bonds to finance President Biden's programs and cover the rising budget deficit.
- Fitch just downgraded US Debt due to unsustainable spending and ineffective governance, which potentially adds some risk premium to the nominal yields.
All of these variables potently increase the market supply of US Treasuries, at a time when the demand is vanishing. Thus, the cross over the 4% yield red line potentially signals the march towards the 5% yield level on 10Y Treasuries.
Higher long-term yields have a negative effect on the stock market for several reasons.
- As interest rates increase, the present value of future cash flows decreases, which reduces the intrinsic value.
- Higher yields tend to reduce the valuation metrics, for example, PE ratios, which is particularly important given the currently elevated valuations with the forward PE ratio for S&P 500 at 21.
- Based on relative yields, comparing the earnings yield and the nominal bond yield, the demand for stocks falls as investors shift their investments from stocks to safer and higher-yielding Treasury Bonds.
- The bear steepening of the yield curve could force the Fed to continue hiking. The stock market digested the Fed hikes up to the current level, but further hikes could have a disproportionally more negative effect on the stock market because the further tightening increases the probability of a very deep and long recession.
- Economy-wide, higher nominal long-term interest rates boost the mortgage rates even higher, which could eventually cause a much deeper housing market correction.
Thus, the cross above the 4% yield level is negative for the stock market.
But what if the yields fall and stay below the 4% level? Would that boost the stock market and extend the summer rally?
Given the variables previously explained, the only way the 10Y Treasury Yields fall below the 4% level towards 3.5% or lower is if the US economy enters a recession, and that recession causes a significant fall in inflation.
Bottom-up analysts are predicting a strong earnings growth in Q4 of 2023 and the whole 2024 - they are not predicting a recession. This is keeping the market rally going and keeping the soft-landing/no-landing narrative alive. Thus, the anticipated recession would actually be a big surprise to Wall Street analysts - and this would crush the stock market due to the earnings expectations downgrades.
So, the fall in the 10Y Yields below the 4% level (and lower) would also be a negative for the stock market, as it would signal an imminent recession.
That's the checkmate situation. At this level, higher yields are likely to crush the valuation metrics, while lower yields are likely to crush the earnings estimates.
SPY implications
The most popular ETF with institutional and retail investors that closely tracks the S&P 500 ( SPY ) has finally recorded a down week. Is this just another buyable dip or the beginning of a much deeper selloff?
The SPY chart below shows a strong technical uptrend since the October 2022 low, which gained momentum after the March 2023 banking crisis, and accelerated the move upwards after the June 1 debt ceiling resolution, rising in a melt-up fashion during the summer months of June and July.
The selloff started as the 10Y Treasury Bond breached the 4% level, initially due to the leak of the BOJ tweaking the yield curve, with the follow-up after the Fitch US debt downgrade.
The S&P500 is still up by nearly 20% YTD. When you look at the SPY sector leadership, the rally has been led by three sectors, Communications ( XLC ) up by 43%, Consumer Discretionary ( XLY ) up by 34%, and Technology ( XLK ) up by 39%. These sectors were led by the seven megacaps Apple ( AAPL ), Microsoft ( MSFT ), Alphabet ( GOOG ), Meta ( META ), Amazon ( AMZN ), Tesla ( TSLA ), and Nvidia ( NVDA ), with generative AI as the common theme. The recent earnings season indicated that, while AI could boost the earnings in the future, it is unlikely to have an immediate significant effect on profitability for most AI leaders.
Here are the valuation metrics for SPY and all SPY sectors. With the SPY 2023 PE at nearly 21, the increase in 10Y Yields sustainably above the 4% level is likely to cause a significant valuation contraction.
Here is the table with the earnings estimates for SPY and all SPY sectors. Analysts are predicting a 7.3% earnings growth for Q4 2023 and 11.7% earnings growth for 2024. The sustainable decrease in 10Y Treasury yields below the 4% level is likely to signal a demand for Treasuries due to a recession, which will require a significant earnings expectation downgrade, and thus, a significant correction in price.
So, it is a checkmate situation. Any further economic growth is likely to cause higher long-term interest rates, which is negative for the stock market. At the same time, lower long-term interest rates are likely to signal a recession, which is also negative for the stock market. The bear market is set to resume.
For further details see:
SPY: It's A Checkmate Situation - The Bear Is Set To Resume