The slide in stock markets over the past few trading sessions has been partly blamed on an unexpected surge in long-term bond yields and concerns that inflationary pressures may be building up in the economy.
Should investors take this as a signal to lighten up on stock exposure in their portfolios ahead of a meaningful correction? Not so fast, says RBC.
In an updated outlook on the equity market released Tuesday, Lori Calvasina, head of U.S. Equity Research for RBC Capital Markets, says she’s not overly concerned about the surge in the 10-year U.S. Treasury yield, which is now back to its highest level in more than a year.
There are three reasons why.
First, dividend yields on stocks are still much more appealing than what’s offered by the government bond market. The number of companies in the S&P 500 that currently have a dividend yield in excess of the 10-year Treasury yield stands at 51.5 per cent.
While that’s down from 64 per cent at the start of the year, it is still within a range that is typically followed by a 17-per-cent gain in the S&P 500 over the next 12 months, Ms. Calvasina pointed out. “This indicator seems unlikely to return to a range that has been problematic for stocks in recent years until it hits 3.3 per cent,” she says. On Tuesday, the 10-year yield was only at 1.35 per cent - albeit that’s far above the 0.50 per cent it bottomed out at last summer.
Her second reason has to do with the current earnings yield - which measures the value of an investment by taking a company’s earnings per share over the past 12 months and dividing it by the current share price. The earnings yield of the S&P 500 against the 10-year Treasury yield has moved down to the low end of its post financial crisis range, similar to 2017-2018, she notes.
While that’s less appealing than it was last March when it was at the high end of its post financial crisis range, the indicator is still within a range that has been followed by 9.3-per-cent average gains in the S&P 500 over the next 12-month period.
“In other words, this analysis is acknowledging the case for a short term pullback in the S&P 500, but isn’t necessarily signalling that longer-term investors should head for the exit. We think there’s also an important difference between the 2018 back drop – when the trade war was a threat to the global and US economies – and today when GDP forecasts are rising rapidly,” she said.
Thirdly, Ms. Calvasina’s research of historic trends shows that stocks often struggle when yields move up more than about 275 basis points. For this to happen now, the 10-year yield would need to hit 3.26 per cent. That’s a long way to go.
Instead of thinking of higher yields as a signal to exit the equity market, Ms. Calvasina suggests taking it as a cue to adjust portfolio allocations. Real estate investment trusts, consumer discretionary and technology stocks tend to underperform when yields are rising, while financials and industrials tend to do better.
RBC last month set a 2021 target for the S&P 500 of 4,100. That would represent a healthy full-year gain of 9 per cent, or 6.7 per cent higher from current levels. RBC also cautioned that there would likely be a pullback in equity values before seeing those types of levels.
In RBC’s updated view, Ms. Calvasina and her team said they believe that target is still achievable, even if the timing is less clear than ever. A meaningful pullback “has the potential to start at any time but may not emerge until the 2nd half [of the year] given a lack of near-term catalysts,” she said.
She explained further: “With evidence of consumer resiliency in economic data and positive developments on vaccines and the virus continuing to pile up, it is tough to imagine a growth or virus scare taking stocks down any time soon. The most likely candidate for a catalyst, in our minds, remains something that is completely unanticipated by investors (similar to the China trade war, which came from out of nowhere in 2018, helping turn the year into a rare down one). It also seems too early for markets to have clear visibility into known issues such as the potential for Fed tapering/rate hikes and higher corporate taxes, which we think are likely to be more material to the 2022 outlook and thus unlikely to hit stocks until the 2nd half. The potential for margin hits from higher commodity costs is important to monitor, but companies are not ringing the alarm yet.”
For portfolio allocation, she continues to prefer non-U.S. stocks over U.S. equities, value stocks over growth stocks, and small-cap stocks over large. She also recommends investors remain overweight in financials, materials, and energy.
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