History shows rising yields are not bad for stocks

Published Thu, Sep 22 20165:17 PM EDTUpdated Thu, Sep 22 20165:24 PM EDT

History shows rising yields are not as negative for stocks as investors fear right now, but there's one caveat: Earnings must grow at a faster pace than rates. Those are the findings of a statistical analysis from James Paulsen, Wells Capital Management's chief investment strategist. "Since 1950, the stock market has done fine with rising yields provided the annual growth in earnings per share exceeds the 10-year Treasury yield," wrote Paulsen on Thursday. "Indeed, historically, when yields have risen while earnings growth was above the 10-year yield, the S & P 500 increased by almost 10 percent per annum." Paulsen's earnings-yield indicator compares the annual growth of S & P 500 earnings in relation to the 10-year Treasury yield. When the EYI metric was above zero — that is when earnings growth is greater than the 10-year rate — the annual return for the S & P 500 was significantly higher. The robust gains also came with less volatility, as shown on the chart below. Source: Wells Capital Management In fact, the direction of the earnings-yield indicator was a key factor in determining the direction of stocks, more so than yields alone, said Paulsen. "For the stock market, the pace of earnings growth 'relative' to the bond yield is of paramount importance," he noted. The investor points to periods in the late 1970s and early 1980s as examples when, even though earnings grew by 10 percent, it was not enough to lift the stock market as the yield of the 10-year Treasury was higher at 15 percent. As a result, stocks are likely to continue their upward momentum, predicts Paulsen, who believes the bar has been set low for S & P 500 earnings to surpass the yield on the 10-year Treasury. "In the contemporary recovery, even paltry earnings gains of 3 percent to 4 percent may be enough to keep the stock market rising since the 10-year yield has seldom risen above 3 percent," the strategist wrote in his note. To be sure, companies may have trouble meeting that low bar this year as Wall Street analysts predict S & P 500 earnings growth will be flat, according to Reuters. So going by Paulsen's own theory, it could be tough for the market unless earnings growth picks up this quarter. But Paulsen believes the analysts will turn out wrong and his theory will hold. He writes, "The drag on earnings performance from weak commodity prices has come to an end and we anticipate somewhat improved U.S. and global economic growth in the coming year. This should revive earnings growth and since bond yields remain extraordinarily low, even modest earnings growth should soon return the EYI positive."

Traders in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange.

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History shows rising yields are not as negative for stocks as investors fear right now, but there's one caveat: Earnings must grow at a faster pace than rates.

Those are the findings of a statistical analysis from James Paulsen, Wells Capital Management's chief investment strategist.

"Since 1950, the stock market has done fine with rising yields provided the annual growth in earnings per share exceeds the 10-year Treasury yield," wrote Paulsen on Thursday. "Indeed, historically, when yields have risen while earnings growth was above the 10-year yield, the S&P 500 increased by almost 10 percent per annum."

Paulsen's earnings-yield indicator compares the annual growth of S&P 500 earnings in relation to the 10-year Treasury yield. When the EYI metric was above zero — that is when earnings growth is greater than the 10-year rate — the annual return for the S&P 500 was significantly higher. The robust gains also came with less volatility, as shown on the chart below.