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The market’s main focus has evolved over the past 18 months from pandemic-related unemployment, to central bank policy, and now on to recovery. All the while, one indicator – inflation adjusted (or real) bond yields – has provided the best guidance for global equity investors. These yields currently provide a bullish signal for stocks – but to what degree may very well depend on whether tech stocks can regain their market leadership.

The importance of real yields lies with central bank policy. Led by the U.S. Federal Reserve, major central banks pushed bond yields well below the rate of inflation in order to offset some of the negative economic effects of the pandemic. The result was that U.S. 10-year real bond yields went negative, meaning that bond investors actually lose money every year once inflation is taken into account.

Negative yields on bonds made equities more attractive, even if the S&P 500′s potential earnings yield is always far less reliable than bonds – companies can miss earnings projections.

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The lower real yields went, the more attractive equities became. The end result is that stock valuations in terms of forward earnings yield move higher as real bond yields fall – more investors avoid the negative inflation-adjusted bond yields and buy equities for earnings growth, pushing valuations higher.

Inflection point?

S&P 500 forward

P/E ratio

10-year TIPS

yield (inverted)

28.5

-1.5%

26.5

-1.0

24.5

-0.5

22.5

20.5

0.0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2016

2017

2018

2019

2020

2021

THE GLOBE AND MAIL, SOURCE: bloomberg;

scott barlow

Inflection point?

S&P 500 forward P/E ratio

10-year TIPS yield (inverted)

28.5

-1.5%

26.5

-1.0

24.5

-0.5

22.5

20.5

0.0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2016

2017

2018

2019

2020

2021

THE GLOBE AND MAIL, SOURCE: bloomberg; scott barlow

Inflection point?

S&P 500 forward P/E ratio

10-year TIPS yield (inverted)

28.5

-1.5%

26.5

-1.0

24.5

-0.5

22.5

20.5

0.0

18.5

0.5

16.5

1.0

14.5

12.5

1.5

2016

2017

2018

2019

2020

2021

THE GLOBE AND MAIL, SOURCE: bloomberg; scott barlow

The first accompanying chart shows this relationship between real yields, using U.S. Treasury Inflation Protected Securities (TIPS) as a proxy, and stock valuations (note that TIPS yield is plotted inversely to better show the trend).

The lower real yields/higher stock valuations trend is clear on the chart and the close association is backed up by correlation calculations. It is interesting also that price-to-earnings ratios bottomed twice at roughly the 14 times level, which corresponds on the chart with the 1.15-per-cent high for real yields hit in November, 2018.

Recently, the lines on the chart have diverged slightly beginning in mid-April with real yields falling while valuation levels remained stable and did not rise to track falling yields. On the surface, this suggests equity prices and valuations should climb to close the gap in the chart.

It’s important to note that sector leadership within the S&P 500 plays an important role here. That said, the S&P 500 average P/E ratio plotted on the chart cannot fully reflect any changes in sector leadership away from technology. The tech sector’s dominance of all index data – the top five tech stocks have accounted for between 20 and 25 per cent of total market capitalization in recent years – obscures outperformance by smaller stocks. For instance, a change in P/E ratio for Apple Inc. affects the average multiple for the index 30 times more than an equivalent change for Fedex Corp. in the market cap-weighted benchmark.

With this in mind, comparing the performance of the conventional S&P 500 to the S&P 500 Equal Weight Index – where changes in stock prices and valuations are counted equally for all stocks – offers valuable insight.

When a small number of mega-cap stocks is outperforming, the usual market-cap-weighted index will outperform. However, when smaller stocks are outperforming the mega caps, the equal weight index will outperform. This pattern is associated with value investing strategies outperforming growth stocks because mega caps are almost by definition growth stocks – that’s how they got big enough to dominate the benchmark.

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Our second chart compares the value of US$1,000 invested in both the conventional and equal weight S&P 500 indexes from the market bottom in March, 2020. We can see that since the beginning of November, 2020, when clinical trials showed great promise of the Pfizer vaccine in protecting against the COVID-19 virus, the equal weight index has beaten the S&P 500, consistent with the value stock rally on reopening optimism. This value stock leadership is also consistent with early cycle market behaviour (the first stage after a recession, when the most beaten-down stocks recover).

July has seen a change in the trend. Month to date, the conventional S&P 500 has outperformed the equal weight index by 1.5 per cent. This is a small sample, but might signal the re-emergence of largest cap stocks as outperformers.

The two charts indicate a market that, if not at an inflexion point, is ready for a change in sector leadership. I suspect that with the pace of economic and profit growth moderating to levels closer to the historical average, that the rally in small and mid-cap stocks is likely to stall – smaller companies tend to outperform in early cycle conditions – and this means that the equal weight index outperformance may be close to an end.

Inflation-adjusted interest rates near current levels will continue to support equity valuations, attracting investment assets away from bond markets. Whether the recent divergence on the first chart will close or not depends on the performance of the large-cap technology stocks and this is not easy to predict.

Investors looking to confirm a change in sector leadership might want to keep a close eye on the relative performance of the S&P 500 and the S&P 500 Equal Weight Index.

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