Two Crucial Questions


Q With price/earnings ratios high, how vulnerable is the stock market to a jump in interest rates?

A With yields on bonds so low, investors have shifted into stocks in search of higher returns. That has pushed up valuations, especially for bond-like stocks of stable companies.

But earnings yields (earnings/price ratios) have not declined as much as bond yields. Compared to bond yields, stock valuations are attractive relative to historical norms. In fact, the median earnings yield of S&P 500 stocks (4.75%) exceeds the 10-year Treasury bond yield (2.20%) by 2.55% — well above the average spread of 1.48% since 1994. 

Today's favorable spread will only help so much if resurgent inflation pushes bond yields sharply higher. All else equal, if 10-year Treasury yields rise to 4.5% and the spread returns to the historical norm, the median S&P 500 stock would drop 21%. Of course, all else is never equal. If bond yields rise because of better economic growth, improving profit-growth expectations could counter some of the downward pressure on P/E ratios.

Q Are bond yields near seven-month lows because the economy is set to slow or because inflation expectations have dropped?

A Consensus estimates for U.S. economic growth and inflation have held remarkably steady, with 2017 and 2018 forecasts for both hardly budging since January. Yet term spreads, the difference between yields on short- and long-term bonds, have dropped close to nine-year lows.

Historically, a narrowing term spread has signaled caution about the economic outlook. When the yield curve inverts, with short-term yields above long-term yields, history suggests the risk of a recession is high. But a flattening in the yield curve has not been associated with weaker economic growth, according to Capital Economics.

At least in part, U.S. bond yields have dropped because easy monetary policy in Japan, the U.K., and the euro zone has pushed foreign investors into U.S. bonds. Some economists say a global glut of savings, driven partly by aging populations, has pressured bond yields. This year's drop in credit spreads, the difference in yields between low- and high-quality bonds, suggests bond investors are not worried about a recession.


The Dow Transports have moved within 1% of their all-time high of 9,593.95. A close above that level would reconfirm the bullish primary trend — and suggest bond yields have not slumped because of pessimism on the U.S. economy. For now, our buy lists have 94.8% in stocks.

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