The S&P 500 has shown gains in 2024; however, the rise in bond yields introduces a heightened risk of a significant decline for the index.
Continuing the Rally
In January, the S&P 500 has experienced an increase of approximately 2%, continuing its rally since reaching a low in late October. There are two primary drivers of this upward trend. Firstly, the market anticipates aggressive interest rate cuts by the Federal Reserve due to a decrease in the rate of inflation from its peak in 2022. This situation allows the Fed room to support economic growth. Secondly, the so-called Magnificent Seven tech outperformers have contributed to the S&P 500’s positive performance.
The Impact of Rising Yields
One critical concern arises from the fact that the 10-year Treasury yield has risen above 4.1% after closing just below 3.9% at the end of 2023.
The higher yield diminishes the attractiveness of equities. Presently, the S&P 500 trades at approximately 19.8 times the expected earnings per share in the coming year. This means that, for every $19.80 investors spend to own the index, they receive $1 of earnings, resulting in a yield of 5.05%. However, this yield is merely one percentage point higher than the 10-year Treasury yield, despite stocks being considerably riskier than Treasury notes. Taking on additional risk should lead to greater rewards.
A Word of Caution
Although the dwindling appeal of stocks has not yet affected buying interest, with the index hitting record highs this week, investing in the index solely because others are complacent is a naïve approach at best.
The Interplay Between Bond Yields and the S&P 500
Recent data from Evercore suggests that there is a notable correlation between the current 10-year yield and the S&P 500. Specifically, the 10-year yield has been hovering around the 4500 mark, which signifies a potential 7% downside from its current level of 4850. While the fact that equities appear expensive compared to bonds does not necessarily imply an immediate sell-off, it does highlight the possibility of a wave of selling if certain risk factors come into play.
One such risk factor is the potential increase in yields. Inflation has been slightly above the Federal Reserve’s target of 2% for some time now, with the latest readings indicating a rate of just over 3% year over year. This suggests that the Fed may not be able to cut rates as aggressively as the market anticipates. In such a scenario, the 10-year yield could climb higher and erase a significant portion of the additional premium offered by stock investments. Consequently, this could prompt a decline in the S&P 500.
Another crucial factor to consider is corporate earnings. Should companies meet or surpass expectations, while analysts’ estimates for earnings of S&P 500 component companies continue to rise, it is likely that the index yield will provide support for further share-price gains. However, it is important to note that the earnings landscape can quickly turn bleak. Some companies, such as FedEx, have already started experiencing a pinch due to higher interest rates, leading them to issue conservative revenue and profit guidance.
It is worth keeping an eye on how these factors evolve and how they could potentially impact the relationship between bond yields and the S&P 500.