In recent reports, the increasing yields of various maturity U.S. Treasury bonds have become a focal point in the market. Analysts note that for the first time in 25 years, U.S. bond yields have surpassed the profit rates of the S&P 500 stock index, putting pressure on the U.S. stock market.
Traditionally, stocks were perceived to have greater growth potential compared to bonds, resulting in a valuation premium for stocks over bonds in terms of earnings yield. Since the global financial crisis, a shift in market dynamics has seen stocks outperforming bonds in terms of earnings yield, making stocks a more attractive asset class.
However, this trend seems to be reversing now. Last week, the U.S. Treasury bond market experienced significant sell-offs, pushing yields to levels not seen in decades. With the 10-year U.S. bond yield surpassing 5%, the relative advantage of bonds over stocks has returned to levels seen approximately 25 years ago, creating new challenges for the stock market.
Economist Robert Shiller from Yale University utilized his cyclically-adjusted price-to-earnings ratio (CAPE) model to calculate the latest data. He suggests that over the next decade, the S&P 500 index may only outperform bonds by around 1% annually. This indicates that investors’ room for error in their profit expectations from businesses has significantly narrowed. Despite the contraction in the stock market’s price-to-earnings ratio to accommodate higher bond yields, the stock market still faces certain pressures.
The core change currently lies in the fact that the alternative value of bonds has risen to levels not seen in 25 years. With the 10-year U.S. bond yield surpassing 5% and stock earnings yield falling below bond yields, the investment landscape where “stocks outperform bonds” is undergoing a noticeable reversal. Investors must reassess the expected earnings growth of S&P 500 companies and the relative attractiveness of stocks compared to bonds.
According to a report by Business Insider, market focus is predominantly on the U.S. bond market. Distinct concerns in macroeconomics, finance, and geopolitical issues are intertwining to drive the continuous rise in U.S. bond yields, prompting investors to start worrying that the next wave of pressure might shift towards the stock market. When U.S. Treasury bonds offer almost risk-free returns that are more attractive, investors may find locking in a 5% return for a few years more appealing than bearing the risks of the stock market.
Senior investment portfolio manager Steve Eisman mentioned that without a rapid decrease in U.S. bond yields below 5%, the market could face a correction.
Farzin Azarm, Managing Director of Mizuho Securities, also warned that the market could face a “severe correction,” listing bond market volatility as one of the potential factors. If the earnings growth of large tech companies slows down, the risk of a correction due to high valuations will significantly increase.
He further noted that market differentiation has become increasingly evident, with the upcoming third-quarter earnings announcements in October and November being critical for market operations.