Searching for buying opportunities in the wake of the bond-market storm

Published Sat, Feb 27 20217:41 AM ESTUpdated Sat, Feb 27 202112:32 PM EST

A nasty gale tore through the bond market the past month, sending yields flying, upending portfolios and whipping around valuation models. With a tentative calm returning on Friday, it's probably time to assess the damage and look for any valuable windfall that was knocked loose. Not every strong market reaction is an overreaction, and the swirl in stock and bond prices is almost entirely about an urgent repricing for an economic acceleration that appears quite likely. Yet when prices start to dart around as fast as they did last week, with 10-year Treasuries running briefly above 1.6% from 1.13% two weeks earlier, there's a better chance of overshoots. Bonds themselves regrouped Friday, the 10-year settling all the way back to 1.41%, helped by a likely mechanical month-end rebalancing out of equities into fixed-income after stocks' massive outperformance this year. But bonds also appear quite oversold on several measures and the massive flow of cash out of long-term Treasury ETFs Thursday hint at lopsided pessimistic positioning that might have been climactic in the short term. Bespoke Investment Group points out that the long-term Treasury index was down 10% year to date, the earliest point in any year for such a big loss. Historically, the risk-reward tradeoff became more favorable for buying bonds after such a quick loss. This is not to say that the march higher in yields is over. But with the Fed resolute in standing pat on rates for a long time to come, the rise might well slow. And with investment-grade corporate yields now above 2.1% from a low below 1.8% a few weeks ago, bonds at least can serve as slightly more of a buffer along with equities in a portfolio. Big Five resets without major damage The enthusiasm over a quickening economy that's lifted yields has also punished shares of huge secular-growth companies, mostly in tech, that had been prized for their ability to grow in a weak economy. The Nasdaq 100 bounced modestly Friday but fell 4% on the week and is 7% off its record high. Contrary to many doomsaying arguments from last summer – when the big complaint was the market's overreliance on just a few enormous stocks – the Big Five S & P 500 giants (Apple, Microsoft, Amazon, Alphabet and Facebook) have managed to fall an average of 11% from their high while the S & P 500 itself is only off 3.5% from its recent peak. Yes, it's been a rotational market, with financials, travel plays, energy and industrials taking up most of the slack. But these groups got extended and no longer appear particularly undervalued, which explains the broader S & P pullback. The yield rise makes for awkward times for Wall Street strategists who have leaned too heavily on the idea that elevated equity valuations are not a concern because bond yields are so low. It's true, the so-called equity risk premium – the difference between the earnings yield and Treasury yields - is now narrower than most times since 2009, there is no fixed or essential relationship here to rely upon. In the '90s, earnings yields were always lower than that of bonds, since 2000 always higher. Still, it's reasonable to assume the stock market will be reliant on earnings growth rather than valuation expansion for further upside. But this has already been the case for about nine months: The forward price/earnings ratio for the S & P 500 is 22 – the exact level where it stood at the end of May 2020, when the index was 20% lower. Profit forecasts continue to climb: FactSet says first-quarter numbers are up 5 percentage points in the past seven weeks. On average, estimates decline by about 3 percentage points by this point in a quarter. Value in FANG? It's worth asking, too, if the compression of big growth-stock valuations in the cyclical rotation and bond sell-off has surfaced some value. Here's a look at the forward free-cash-flow yields of Alphabet and Facebook , both near 4%, which is about the same as junk-bond yields. Granted, this is not apples-to-apples. FCF yield is a gauge of profitability but not cash paid out to investors. But needless to say, for most of Wall Street history speculative-grade debt has yielded vastly more than growth stocks offered as a free-cash-flow yield. And while the market debate has focused on the risks of another "taper tantrum" sending yields higher still, based on fears of an eventually less-easy Fed, the original taper tantrum in 2013 coincided with a period of sharp outperformance by Big Tech. Lost in the rotation The headlong rush of investor cash into big-cap growth last summer and then out of growth into anything cyclical over the past four months has bypassed a class of stocks in the middle. Namely, higher-quality companies with a penchant for distributing cash to investors out of their profits look like relative bargains. The ProShares S & P 500 Dividend Aristocrats ETF (NOBL) , a basket of companies with a decades-long record of growing dividends, now trades at a 15% discount to the S & P 500 based on forward P/E, near its lowest relative valuation in a decade. Note these are dividend growers, not simply high-dividend-yield stocks, so they aren't as directly sensitive to each uptick in bond yields. Similarly, the Invesco Buyback Achievers ETF (PKW) trades at little more than half the S & P 500's valuation, is full of both financials and tech, and arguably is well-positioned to regain some attention as the year goes on. Buyback announcements have come roaring back, companies are loaded with cash and cheap debt, and these stocks are a mix of growth and cyclical proxies. None of these sectors would be fully insulated from a deeper correction in the broader market, of course. For now, the S & P is still in the "routine pullback" zone, perfectly normal bull-market retrenchment, though with the gears grinding a bit on the once-flawless value-over-growth rotation. The S & P could lose another 4% or so before breaking the December low, which history and lore suggest is a bigger warning sign early in a year. Sentiment and positioning have moderated from recent giddy extremes, though the tape is far from washed out. Rampant SPAC issuance and the wild performance of crowded "disruptive-technology" strategies continue to give some seasoned investors reasons to fret – and yet the credit markets are showing no real stress to speak of. As always, there is push-and-pull in the markets and plausible points on either side. As it all plays out, though, the market has started to serve up a few fresh opportunities not dependent on getting every feint and flourish correct.

Traders on the floor of the New York Stock Exchange

Source: NYSE

A nasty gale tore through the bond market the past month, sending yields flying, upending portfolios and whipping around valuation models.

With a tentative calm returning on Friday, it's probably time to assess the damage and look for any valuable windfall that was knocked loose.

Not every strong market reaction is an overreaction, and the swirl in stock and bond prices is almost entirely about an urgent repricing for an economic acceleration that appears quite likely. Yet when prices start to dart around as fast as they did last week, with 10-year Treasuries running briefly above 1.6% from 1.13% two weeks earlier, there's a better chance of overshoots.

Bonds themselves regrouped Friday, the 10-year settling all the way back to 1.41%, helped by a likely mechanical month-end rebalancing out of equities into fixed-income after stocks' massive outperformance this year.