Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: The S&P 500 closed above the 2000 threshold for the first time in its history this week, albeit just by just the slimmest of margins the past two days. Now that the psychological tractor beam is done, will the market decide to take a breather here?
Stovall: I think investors would assume the market will take a breather, and it certainly could. We are heading into the worst month of the year for the S&P 500. September ranks 12th in terms of average performance for the S&P 500 since World War II, and is the only month in which the S&P 500 declines more frequently than it advances. So there’s certainly a possibility.
Yet, when I look at the 30 days after the S&P 500 crossed the 500, 1000, and 1500 levels, I found that the market was up another 5% in the next 30 days. So if this kind of average persists this time around—and there’s no guarantee it will—we could see an S&P 500 at 2100 by the end of September.
EQ: In this week’s Sector Watch, you looked at the prospects of a significant decline in the bond market as Fed rates are expected to increase by the second half of 2015, if not sooner. For the most part, the bond market seems to be a larger, slower asset class than stocks. So would investors have to categorize bull and bear markets differently?
Stovall: Yes, probably so because I went back to the mid-1980s, which is as far back as there is daily total return data on the Barclays Aggregate, and I found that there were 10 declines of between 5-10%, and six declines between 10-15%, but none that was higher than 15%. The traditional definition of a stock bear market is a decline of 20% or more, and we’ve had 12 of them since World War II. Yet for bonds, we’ve actually had nothing higher than 14% since 1986.
If you look at annual performances going back to the mid-1970s for the Barclays Aggregate, we’ve only seen this index down three times, with the worst performance in 1994 when it fell by less than 3%. So it is intriguing that bonds tend to fall less. So, we probably would have to come up with a different threshold for bonds. As an example, maybe a bear market is 10% for bonds versus the 20% line for stocks.
EQ: Last year, many market experts said that the bond market ended a 30-year bull run. Is it possible that investors may be setting their expectations on certain realities that don’t exist because of their experience over the past three decades?
Stovall: That’s certainly a possibility. When you think about data going back to 1980-81, you’re talking about 30-plus years. That’s a lot of data, but it may consist of really just one cycle or at least half of one cycle because we had short-term rates up near 20% and now we’re down close to 2% again. Chances are we’re not going to see that kind of a falloff in rates anytime soon. The next direction in the secular market in bonds is likely higher interest rates.
If you look at the normal relationship between the yield on the 10-year note and inflation as measured by CPI, it’s usually 2.2% higher. So if this were a more normal environment, the yield on the 10-year note would probably be closer to 4.2% as compared with the 2.3% that we see today.
EQ: Bond prices and interest rates have gone against expectations for most of this year. What are some potential factors going forward for that trend to continue? If you’re a bond investor, what are some reasons to consider holding?
Stovall: I think one reason why bonds did relatively well early this year was a result of rebalancing. At the end of 2013, because stocks were up 30% and bonds were down, a 60/40 exposure to stocks and bonds was actually 67% stocks and 33% bonds by the end of 2013. So if you were to rebalance to get back to normal, it would’ve added a lot of money to the bond market.
Second, because we had a very weak first quarter of GDP growth—actually a decline of close to 3%–many people were nervous and either kept their bonds or gravitated toward owning more bonds out of a flight to safety.
A possible third level of support to bonds could be from a competitive perspective. Bond yields in Europe are about half of what they are in the U.S., so some investors who are searching for yields in Europe might be looking to the U.S. for better returns. Also, other investors around the globe who are looking for more security or transparency may be looking to U.S. bonds as well, which is a reason why the dollar has strengthened and the bond yields have continued to fall.
From a technical perspective, because the yield of the 10-year note broke below the 2.45% level, we now think that it could threaten or challenge the 2% level before we head back up to the 3% level.
EQ: Looking at the capital levels of the bond market versus the stock market, there’s still a significantly higher level of capital in bonds than in stocks. If the bond market does enter a bear market from here with interest rates rising, could that potentially benefit stocks because of a great rotation that we have yet to see?
Stovall: Yes, I think it could. Historically, what we have seen is that as interest rates rise from relatively low levels, stocks have continued to do fairly well. Looking from an asset class perspective, from the end of 1976 to the end of August of this year, whenever the yield on the 10-year note rose in a particular month, the total return change for the S&P 500 was a gain of 0.9%, but for the Barclays Aggregate was a decline of 0.7%.
If we break it out a little finer, we find that stocks do very well even in a rising rate environment when the yield on the 10-year note is between 0-3% as the S&P 500 has gained an average of 1.9% in each of those months. When it’s between 3-4%, the S&P 500 gained 1.7%. So the return was still positive but lesser than when rates were much lower. We continue to have an average increase for stock prices up until the line in the sand of 6%, above which the average price change for the S&P 500 becomes negative.
The reason for that is investors try to rationalize for what is causing rates to up, and what’s causing rates to go up is an improving economy. If you have an improving economy, it is also going to benefit corporate earnings, and higher corporate earnings will allow P/E multiple expansion and prices to move higher.