Last Friday I published a short term chart of the US 10year bond yield. That yield actually rose further in late US trading, ahead of the weekend. During the course of the week the moves in the bond markets finally seemed to have an impact on the equity space with the Dow Jones recording two days of triple digit losses as the week drew to a close.
The question is whether or not this could herald the end of the longest equity market rally in history? Certainly, from a technical perspective it looks possible that we could have already reached the end of an upside 5-wave sequence, in both the Dow Jones and the S+P 500, that started way back at the beginning of Q2 2009.
Earlier this year it looked like the party was coming to an end when the equity markets suffered some hefty, geopolitically induced falls. However, calm was restored and as the spring turned to summer, the equity train rumbled on once more and by the 21st September the S+P 500 had set a new all time record high at 2940. That high was matched again last week before tailing off on Thursday and Friday.
So, for the purposes of this article I am focusing on the S+P 500 because it’s a broader range benchmark than the Dow Jones which is made up of just 30 component stocks. Currently the S+P 500 has a PE (price to earnings) ratio of around 23.5 which means the price of the index is trading at an average of 23.5 times the level of past earnings.
Historically that’s pretty high. Ok, it did get to a staggering 123 at one point during the financial crisis, back in 2009, but the mean average PE ratio over the past 120 years has been around 15.70.
The current dividend yield across the benchmark is around 1.8% which is conversely low too and that’s not exactly attractive with interest rates now on the rise. The mean average on that over the same long term time frame is 4.3%.
A decade of QE and accompanying low interest rates drove money into the equity and bond markets which of course was understandable. There was literally nowhere else for that money to go. However, with bond yields continuing to rise last week; it shouldn’t come as much of a surprise to see the S+P fall back too. Incidentally, the bond market is probably not the place to invest in yet either, if one is concerned about higher interest rates.
Rising US interest rates has had an impact on the currency markets too and already this year we have seen that play out in some of the emerging market currencies with increased volatility in the likes of the Turkish Lire, Argentinian Peso and South African Rand as they struggle to fend off a rising dollar.
That volatility is yet to spread to some of the major currencies like the EUR and the JPY, but I think it could be short sighted to assume it won’t happen. No doubt, that for the past few years’, low equity and bond volatility has kept a lid on that, but if it is on the turn, then we could soon see this change too.
All the time stocks were rising, and even if the dividend yield kept falling, professional money managers were happy to remain invested as long as they had the potential for capital gains. An extremely low cost of carry made equity markets even more attractive.
So, one could even borrow money for next to nothing and invest that in the stock markets and make a very healthy return, so long as the trend kept going. However, remove that capital gain potential and the mood could easily change if interest rates continue to move significantly above dividend yields.
Well, even if the party is now coming to an end, that doesn’t necessarily mean that all stocks are a bad place to be and doesn’t necessarily portend to an equity market crash either. It might just mean that the decade long era of ‘Passive indexing’ could be a thing of the past and ‘selective’ stock picking will be the way forward.
Indeed, I had a few conversations with friends and colleagues about this last week and most of them were a little nervous. They were all concerned and wanted to hear my views. My answer was simple- ‘if you are nervous then you’ve probably answered your own question’.
In the FX business we used have an old saying: “when in doubt, stay out”. Let’s see if that adage takes a firmer grip on the equity markets this week.