Markets

Can stocks and bonds both be right? Making sense of rising equities and ultra-low Treasury yields

Key Points
  • It's not all that hard to reconcile the implied world views of equity and bond investors.
  • Both markets are responding, each in its own way, to the same accommodative Fed, the same scarcity of reliable cash flows and the same investor risk-aversion.
  • The stock market has registered the poor economic outlook where it has the greatest relevance, in the more cyclical areas, which hold less sway in the S&P 500.
  • The bond market is reflecting the Covid-19 shock and bulge in unemployment, which will keep the economy operating way below potential for a while, sapping inflationary pressures.

The stock and bond markets agree on zero right now. Meaning not that they disagree on everything, but that they agree zero is where the Federal Reserve will keep short-term interest rates for the foreseeable future. 

The way equity and government-bond prices incorporate this consensus on zero rates makes it appear to many as if the equity and fixed-income markets are offering divergent messages on the economic outlook. Yet there is less of a disconnect than might be obvious.

The effect on bond yields is pretty straightforward. Market expectations for zero official rates indefinitely is anchoring Treasury yields, with the two-year note at a record low of 0.1% last week and some Fed funds futures contracts pricing in a prospect of negative overnight rates on the more distant horizon. 

This reality makes it tough to impute to the bond set-up much of a signal on what a recovery looks like beyond what is known: The Covid-19 shock and bulge in unemployment will keep the economy operating way below potential for a while, sapping inflationary pressures.

It's become understandably popular to contrast this message of prolonged struggle with the relative resilience over in equity land, where the S&P 500 is up 33% in seven weeks and is less than 14% off its record high, while the Nasdaq is positive for the year. 

But it's not all that hard to reconcile the implied world views of equity and bond investors.

Growth stock dominance

It's first pretty important to define what the stock market represents now. The S&P 500 is now swayed to an unusual degree by a small number of enormous tech companies with dominant businesses and stable profitability.

As has been widely notes, Microsoft, Apple, Amazon, Alphabet and Facebook together amount to more than a fifth of the S&P 500's value, and make up 40% of the Nasdaq. The Nasdaq 100 has outperformed the industrial sector of the S&P 500 by more than 20 percentage points this year. The median stock in the broad S&P 1500 is still down more than 30% from its high.

SunTrust strategist Keith Lerner notes that growth and defensive sectors represent 62% of today's S&P 500, a much higher weight in noncyclical companies than it had historically.

In other words, the stock market has registered the poor economic outlook where it has the greatest relevance, in the more cyclical areas, which hold less sway in the benchmark.

And the same deflationary forces and zero interest-rate floor that have the 10-year Treasury stuck below 0.7% also translate into a hefty premium placed on the scarce supply of reliable long-term cash flows represented by big growth companies.

This doesn't mean the Nasdaq is attractively or correctly valued now. It doesn't change the fact that growth stocks' outperformance over value stocks has stretched to an historic extreme and the trend looks a bit vulnerable to a quick reversal. But the sturdy performance of the big-cap indexes thanks to this group means "the stock market" is not pricing in a cheery economic scenario about to unfold. In fact, signs of a handoff to early-cycle stocks have tentatively emerged the past two weeks, suggesting an improving — if not a satisfying — economic pace.

The well-ingrained behavioral tendencies of markets also argue that stocks and bonds are not in fierce disagreement right now.

'Very bad' to 'less bad'

Throughout history, equities have done better when economic conditions are transitioning from "very bad" to "less bad." For instance, according to Ned Davis Research, the best annualized returns for the S&P 500 have come when unemployment claims were very high but falling (as they have been in recent weeks — albeit lately giving devastating new definition to "very high.")

Equities tend to attempt to look ahead several months and ride the direction of incremental change in conditions. The bond market, meantime, is only likely to start repricing yields aggressively higher if this incremental improvement is seen making the Fed less accommodative or driving inflation expectations higher. And yet, even at such low absolute levels, the spread between short- and long-term Treasury yields has widened quite a bit, which is typical of a market maneuvering for incremental economic improvement.

And when investors have undergone a shock and urgent liquidation of risk assets, as they did in March, the resulting flight to cash and cautious psychology tends to keep Treasuries well-bid while also supporting equity valuations.

Bank of America notes that another $55 billion entered money-market funds in the latest week — taking their assets to a ten-year high relative to total equity market cap — as equity funds saw their largest outflow since the March collapse.

This abiding defensiveness, even as equities have risen nicely off their lows, is also starkly evident in last week's American Association of Individual Investors sentiment poll, showing bearish respondents exceeding bulls by the largest margin since early 2016. This is quite rare to see after stocks have been rallying for weeks, and serves as a contrarian bullish signal that the public remains skeptical of this market.

Source: AAII

This all helps explain how stocks got here and why that doesn't mean they're blithely ignoring the negatives that underpin today's bond prices. But it doesn't express clearly where stocks head in the immediate moment.

The S&P has a bit more to prove on a technical basis, stalled at the upper end of a multi-week range and last week failing in several tries to break back up to April's post-crash high of 2955.

It remains near levels that held the tape captive for six months last year, and the 200-day moving average is just above at 3000. 

Valuations look rich by most every measure, with profit forecasts collapsing and sending the forward price/earnings ratio above 20 for the first time since 2002. Credit markets have improved vastly off the March panic, ratifying the initial rebound rally, but haven't strengthened appreciably in recent weeks. And while traditional investor sentiment is fearful, short-term trading indicators indicate some hot-money overconfidence creeping back in here and there.

There have been some signs of broadening action, with value, financial and cyclical stocks perking up intermittently relative to the technology growth behemoths. But this comeback is not yet assured.

So even if equities and bonds can get along for a while in their current positions — and if entrenched defensiveness among investors should buffer the stock market against anything too nasty on the downside — this remains a "show me" market that's only partially won back the benefit of the doubt.