Introduction

Bond yields have risen sharply over the past weeks/months, which is remarkable given the uncertainties that will last for several months and even years. The fact that stocks haven't benefitted from the cash outflow in bonds is even more surprising. The following evident question is: what does this mean for stocks? Has it already occurred previously, or does this act like a red flag?

Correlation to TLT: Risks Change

First of all, it does matter why rates are increasing. Is it because of inflationary pressure or improving economic fundamentals? In our opinion, the massive amount of 'free money' will inevitably lead to higher inflation (which lessens the damage of the debt burden).

Second, in case that inflation is indeed picking up: which sectors are set to benefit from that situation? REITs, consumer staples, utilities... have price escalation built in their business model. On the other hand, because of their robust cash flows and long-term visibility (regulation), these companies do show higher leverage metrics, albeit debt is generally financed at fixed long-term interest rates. So in essence: rising interest rates don't impact a well-run company. It's the stock market's perception that makes many believe the opportunity cost of choosing between bonds and stocks is still alive. As such, the impact of changes in interest rates doesn't pose problems to the companies on our premium watchlist. It is true that bank stocks tend to benefit from rising interest rates (Russell-2000), but there are many other factors that come into play as well.

Nonetheless, what's correlation looked like over the past years? Is there a tale to draw valid conclusions from? Let's find out.

PepsiCo

Let's take a look at PepsiCo, a consumer staples stock and longtime dividend aristocrat. On average, PEP isn't correlated with the TLT tracker (US Treasury Bonds 20-Year) on a 6-month basis (based on weekly closing prices). As you'll notice below, the stock market as a whole tends to be negatively correlated with bonds (when bond prices rise (interest rates going down), asset managers are rotating out of stocks into treasuries). The fact that PEP isn't that positively or negatively correlated to TLT under extreme circumstances indicates the relatively weak sensitivity to changes in interest rates. There are, however, periods during which PEP may exhibit higher correlation (like in 2013 when bond-proxy stocks were lagging the overall market). All in all, PEP doesn't exhibit pronounced relationship with neither the SPY or TLT.

(Source: Option Generator Research)

Crown Castle International

Let's now turn to CCI, a REIT. In this case, we see more extremes, especially to the upside. As such, CCI can be considered a bond-proxy stock which doesn't mean it's a bad investment during periods of rising interest rates. If you want to own a 3+ % yielding dividend stock with an annualized growth rate of 8%, then CCI is a better long-term opportunity than TLT.

(Source: Option Generator Research)

Nasdaq-100 (QQQ)

Looking at the Nasdaq-100, we generally notice strongly negative correlation. Stated differently, if one expects bonds to drop, the Nasdaq should be able to keep its head up.

(Source: Option Generator Research)

Technical Analysis of the Stock Market: Interesting Items to Keep an Eye on

The Russell-2000 - the US index filled with regional banks and small caps - continues to demonstrate strength relative to the Nasdaq and high-quality momentum stocks. The Smoothed Stochastic Oscillator will be a key metric to watch closely as it might signal a new long-term bull run in cyclical small caps. This, in turn, doesn't necessarily mean that growth stocks are going to decline significantly; as members of Option Generator already know there are always opportunities available on our watchlist which doesn't target cyclical stocks.

(Source: Pro Realtime)

The fact that the technical picture for bond prices looks gloomy and supports the Russell 2000, big tech stocks are also set to break out above their continuation pattern. Adding the reverse SHS confirmation to the equation and a new rally in the Nasdaq may be just around the corner.

(Source: Pro Realtime)

Interest rates seem to rise even more if and when we clearly break below $157.05. This move might result in relative underperformance for bond-proxy stocks (as highlighted above).

As such, we're overweight the strongest tech names with various option strategies, while keeping our exposure to real estate limited.

(Source: Pro Realtime)

Even utilities (XLU) are capitalizing on higher interest rates. It highlights that correlation and thus risk changes over time.

(Source: Option Generator AM Research)

Technically speaking, the average utility stock is flirting with the $65 resistance level. If it manages to break out, a new long-term bull market in utilities may kick off.

(Source: Pro Real Time)