RKT Stock – ‘Earnings to the Moon’ Is Just Latest Justification for Frothy Market
If you are worried that the stock market has gone up too far, you can always find an argument to soothe your fears, and encourage you to invest more. Here is the latest: Earnings are up a lot this year, justifying the rise in stocks.
The case doesn’t come with rocket emojis and a “to the moon” tag, but it might as well: S&P 500 earnings are forecast to have their biggest rise this year since the recovery after the financial implosion of 2008-09. True, a lot of that is about 2020 being so awful—but next year’s rise is also forecast to be a stunner, with Wall Street predicting a bigger rise than in all but two years in the past decade.
The trouble with this line of reasoning is that it is hard to square with last year’s market logic. A year ago, we were a month into a rebound as the valuations of big technology stocks soared, something explained at the time by far lower Treasury yields. That made sense: Lower bond yields make earnings that are expected to grow far into the future look more attractive, and Big Tech is full of those. Growth stocks were a great place to be as the longest-dated Treasury yields plumbed new lows. Valuations should rise when bond yields fall a long way.
Here we come to the problem: Just as lower yields justified a higher valuation for stocks last year, higher yields should mean a lower price-to-earnings multiple—albeit a lower multiple of much higher earnings. Instead, valuations have gone broadly sideways as bond yields first rose and then this month pulled back a bit. The result is that the stock market’s relationship with the bond market has gone haywire.
The strangeness shows up in the correlation between stocks and bond yields. Since the late 1990s higher yields have typically been good for stocks, so they tended to rise and fall together daily—even as over the long run, yields fell and stocks rose.
Last year, this relationship broke down. Investors got into a cycle where bad news on the economy was good news for stocks, because it resulted in such extreme support from the Federal Reserve and the government. The effect canceled out the usual relationship almost entirely, breaking the link between stocks and bonds by late summer.
The old relationship of yields up, stocks up, briefly reasserted itself after the vaccine success and November’s election. Bond yields rose as investors anticipated vaccine-driven economic reopening and more stimulus under President Biden. It was especially true for cheap value stocks, like airlines and banks, which tend to be reliant on economic growth. But it was bad for Big Tech and other growth stocks that don’t much need economic expansion.
The trouble is what happened more recently. Yields dropped a little and growth stocks made more new highs. The tendency for both to move in the same direction, measured by the 50-day correlation of growth stocks to bond yields, has reversed and is at its most negative since the boom times of 1999. Bizarrely, the link between value stocks and bonds has also turned reversed, although not in such an extreme way, as value stocks also made new highs.
The bearish investor can take this as a sign of over-exuberance. When both value and growth do well whatever is going on with bonds, it suggests investors are just blindly buying without caring about reality.
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The bulls point to earnings instead. Who cares if 10-year bond yields are a quarter of a percentage point higher or lower when the expectation is that next year earnings will be 24% higher than they were before the pandemic, and pretty much everyone is beating forecasts already? According to Refinitiv, first-quarter earnings for the S&P 500 are more than 22% above expectations so far, with a record proportion of companies beating already-elevated forecasts.
It could also be that Treasury yields have partially disconnected from the domestic economy. U.S. government bonds are the risk-free rate for the world, and have fallen back this month in part because of weakness in other countries, even as the U.S. reopening remains on track and the economy blossoms.
It is possible for earnings to continue to meet and exceed the extremely high expectations, although the higher they become the harder it gets. My worry is, even that might not be enough to keep stocks at record levels. When Treasury yields resume their upward climb, earnings will once again be an afterthought for the big growth stocks that dominate the market.
Write to James Mackintosh at [email protected] Zoom.com
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