Rates May Surge Higher, Killing The Equity Market Rally

Rates rose on Friday, December 4 to their highest level in some time, with the 10-year closing around 97 bps. It doesn’t sound like much, but consider that the 10-year rate was at 50 bps on August 4, and you can quickly realize that is a pretty big move. Rates could be heading even higher, with stimulus likely coming soon.

The 10-year yield recently broke a downtrend that has been in place since late 2018. It now has its sights set on a resistance level around 1.25%, again a very low level based on historical trends. Still, when equity prices have adjusted for these low rates, even the slightest move higher from here could easily disrupt the rally.

The red line in the chart above as well as below represents a multi-decade downtrend that has been present in the 10-year rate since 1988. What happens when we reach that trend line is a story for another day.

The big problem is that many stocks have seen their stock prices soar on low rates, dragging their cash flow and earnings yields down to account for the low rate environment. It means that as rates on Treasuries rise, the earnings and cash flow yields for some of these big long-term growth stocks will need to adjust higher as well, which means a lower stock price.

The earnings yield is simply the earnings or earning estimates divided by the stock price. Essentially the inverse of the P/E ratio -- another reason we have seen PE ratio soar across the spectrum of equities.

Apple (AAPL) is just one example, with its earnings yield falling to 3.54% this year, its lowest level in years. It simply means that its PE ratio has risen to its highest level in years. The 10-year plunging has driven the move lower in the earnings yield.

In the middle pane, we can see that the spread or the difference between the 10-year rate and Apple’s earnings yield has fallen to 2.57%, its lowest level since late 2015.  However, to keep that spread constant and to adjust for rising rates, the stock price will need to fall, or earnings growth will need to accelerate.

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Disclosure: Mott Capital Management, LLC is a registered investment adviser. Information ...

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