Published On: January 16, 2018
Written by: Ben Atwater and Matt Malick
The equity market has begun 2018 exploding higher, while the yield on the 10-year U.S. Treasury has soared.
For now, these are both excellent signs for stock investors. Expected reflation (which investors are signaling with the higher yield on the 10-year) indicates that many are beginning to price in longer-term economic growth, a favorable environment for a booming market. After all, with stock valuations where they are, robust underlying earnings growth isn’t optional.
As always, there are two sides to every coin.
The near vertical rise in markets, with no pause or pullback, is becoming increasingly unsustainable. The best thing for the health of this nine-year-old bull market is a pause, at least some temporary consolidation of its gains. When charts look vertical, the end can be close at hand. Although we are skeptical of the market’s froth, we would love to see it climb meaningfully higher. This will require a healthy pause or pullback, whereas a continued straight line move aggressively higher is historically how all bubbles burst.
As for the 10-year Treasury yield, the move-up in rates is healthy as the formerly flattening yield curve was a concern. However, if rates move too high, too quickly, bonds will become a competitive alternative to stocks. Higher rates can also impede a debt-dependent government and economy. But, we think that these are not yet concerns.
Years ago, when few believed in this lengthy bull market, we frequently made the argument that one indicator of compelling value for stocks was that the dividend yield of the S&P exceeded that of the 10-year. That, however, is no longer the case. As a matter of fact, even the yield on a 2-year U.S. Treasury (2.00%) is now higher than that of the S&P 500 (1.44%). It is a simple mathematical fact that as the price on the S&P storms higher, the dividend yield falls.
It’s also a fact that more often than not, a strong start to the year for stocks – which we surely have – has been a reliable indicator for a strong full year. The momentum is certainly in our favor, but be alert if markets get too carried away in the first half of 2018.
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