Will March be the death of the "TINA" trade?
February started with the reflation trade and ended with a bond market rout that scrambled stock valuations and caused some to wonder whether this is the end to the fabled "there is no alternative" to stocks notion.
"TINA" has become a mantra of bulls, arguing that yields have been so low that bonds were hardly worth owning as an asset class.
With the S&P 500 up 2% in February, the sector outperformers are associated with the reflation trade —sectors that benefit from the reopening of the U.S. and global economy.
Reflation trade in February
- Energy up 24%
- Banks up 19%
- Industrials up 8%
- Materials up 5%
At the same time, defensive sectors that are not considered cyclical have lagged the markets.
Defensive sectors in February
- Consumer Staples were flat
- Health Care down 2%
- Utilities down 5%
The narrative behind the reflation trade is intact: The vaccination pace is accelerating, the reopening of the U.S. economy is gaining steam, "go big" stimulus is coming, and 2021 earnings estimates have started rising.
But there is a new cloud on the horizon — higher bond yields are putting a lid on high-valuation stocks.
The TINA trade may now be changing, according to Bank of America's Savita Subramanian. "Income investors that were forced into equities for scarce yield may be more likely to move back to traditional fixed income assets and history suggests 1.75% (house forecast) on the 10-yr is the tipping point at which asset allocators begin to shift back into bonds," she said.
Not surprisingly, Subramanian said the sector that does best when rates start rising are financials. The sectors that tend to do worse are defensive: consumer staples, health care, utilities, and real estate.
That is exactly how the market is reacting. As rates rose in February, banks gained and defensive stocks declined.
Another group that has been getting hurt on rising rates is technology stocks, and with good reason, Subramanian said. "Ultra-low rates have ballooned valuations for secular growth stocks since the financial crisis," she said.
Not surprisingly, megacap tech stocks began moving down as soon as rates started rising.
Megacap tech in February
- Apple down 8%
- Xilinx down 4%
- AMD down 4%
- Facebook down 4%
- Microsoft down 1%
The Federal Reserve has been furiously pumping money into the economy, and much of that cash has found its way into the stock market and has been a major factor in why equities have done so well in the last year.
While "liquidity" (how much money is available to buy and sell stocks) is an important factor, stocks have traditionally risen on some combination of:
- An increase in dividends;
- An increase in earnings; or
- An expansion of the P/E multiple.
Vanguard's late founder Jack Bogle used to call dividends and earnings the "fundamental" part of stock investing, while calling stock rises based on expanding P/E ratios the "speculative" part of the market, that is, it represented investors betting on whether earnings might be rising in the future.
Much of the recent expansion in stock prices has been driven by an expansion of the P/E multiple, which sits at roughly 22 times 2021 earnings.
Big-cap technology stocks in particular saw dramatic rises in P/E multiples in 2020. Chip maker Xilinx, for example, went from 25 to 50 times forward earnings. Nvidia went from 30 to 60. Even old-school big-cap tech stocks saw big moves up in their P/E levels last year with Microsoft going from 25 to 35, and Apple leaping from 20 to 35.
These multiples have dropped as interest rates have risen in 2021.
The bad news is that even if bond yields don't move higher, the current move up appears to be putting a ceiling on valuations.
If higher rates are indeed putting a ceiling on stock multiples, then investors will have to rely on dividend increases and genuinely rising earnings (not just expectations) to propel prices forward.
Fortunately, there is good evidence this is happening. Analysts have consistently underestimated the strength of the economic recovery. Earnings estimates for the S&P 500 for the first quarter of 2021 have risen from 16.0% to 21.6% from Jan. 1 to Feb. 26, and second-quarter earnings estimates have also risen, from 45.7 to 50.9% in that period.
It's a two-way battle between the bulls who say the markets can handle higher rates and those who say valuations are still too high, and between those who say the Fed is in danger of losing control of the low interest rate narrative.
Jim Paulsen from Leuthold has been a consistent bull on the rates vs. stocks debate. "As [Fed Chair Jerome] Powell just said, a primary reason that bond yields are rising is because 'real economic growth' (and EPS) is recovering smartly," he said in an email. "Is a 40-basis point rise in the real yield really that worrisome given the surge recently in 2021 EPS estimates almost back to all-time record highs?"
Looming over every investor is the Federal Reserve. Many believe the Fed will likely come under pressure to taper its bond purchases toward the end of this year.
That would put a further lid on stock prices, but the manner in which it is handled could spell the difference between moving sideways and a major drop in the markets.
"If the market begins to believe that the Fed lost control, and the Fed senses that, there's a chance that the Fed will overreact, so we're in a very potentially volatile period," UBS' Art Cashin said.
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