Stocks Slump As Bond Yields Jump


European bond yields have jumped from rock-bottom levels amid a rebound in oil prices and a mild increase in inflation expectations, helping push U.S. bond yields near six-month highs.

Groups highly sensitive to interest rates, including utilities and real estate investment trusts (REITs), have slumped. Groups highly sensitive to the U.S. economy, including transportation and consumer-discretionary stocks, have mostly stalled amid disappointing economic reports.

For now, we intend to watch the averages while looking for opportunities one stock at a time. This week the cash position of our buy lists is going up to about 18% because we are making more downgrades than upgrades. But a big shift in our equity exposure is unlikely unless we get a Dow Theory signal.

With closes above 18,288.63 in the Dow Industrials and 9,217.44 in the Dow Transports, the primary bullish trend would be reconfirmed. With a close below 17,164.95 in the Industrials, recent new lows in the Transports would be confirmed — and the Dow Theory would switch to the bearish camp.

Term premiums

As this week's cover story makes clear, stocks are still cheap relative to bond yields — even though yields on 10-year Treasury notes have jumped above 2.2% from less than 1.9% in mid-April. Still, the speed of the jump has unnerved some investors.

While slumping prices for utility stocks, REITs, and long-term bonds don't necessarily mean the end of the bull market in stocks, the market will be vulnerable if bond yields continue to rise without a related pickup in economic growth.

Whether the Federal Reserve begins to raise short-term interest rates in September or waits until 2016 is not especially crucial. What matters most for stocks is how long-term bond yields react to a Fed rate hike. Term premiums, or the spread between long- and short-term bond yields, are low because inflation expectations are low. "When the Fed decides it's time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates," Fed Chairwoman Janet Yellen warned May 6.

Also crucial will be the factors driving any increase in bond yields. If yields jump because the U.S. and global economy are improving, rising expectations for corporate profits should counter some of the pressure on stock prices. If bond yields jump because of rising inflation, however, price/earnings ratios for stocks of nearly all stripes will be under pressure.

Along those lines, we'd like to see better action in cyclical stocks like the Dow Transports, especially if bond yields continue to rise. If the Dow Industrials close below 17,164.95, our cash position will be increased again.

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