C.J. Lawrence Weekly – The Battle Between Rising Interest Rates and Corporate Earnings Growth is On…CJL Market Monitor at Neutral
The C.J. Lawrence Market Monitor was created in the early 1980s to measure the relative attractiveness of the stock market versus bonds, and to test the internal technical health of the stock market. Over the Monitor’s 38-year history, it has been a useful asset allocation tool. While not developed as a timing model, the SELL signals generated prior to the stock market crash of 1987, and again in the period leading up to the bursting of the internet bubble in 2000, are two of the Market Monitor’s more notable readings. Post financial crisis the Monitor assumed a very bullish stance on equities as record low yields on treasury bonds posed little competition to even modest earnings yields on stocks. But over the past several months the Monitor’s bullishness has moderated as interest rates climbed towards more “normal” levels. The Market Monitor’s current reading is NEUTRAL, with a reading of 0, on a scale of -6 to +6.
Each of the Monitor’s components is constructed to generate individual BUY, HOLD, and SELL signals. Two of its components are driven by the comparison of equity fundamentals to bond yields, two by the direction and rate of change in short- and long-term interest rates, and two by technical and market breadth indicators. Currently the two components incorporating equity fundamentals are positive and neutral, the two year-over-year bond yield comparison models are negative, and the technical models are positive and neutral. The challenge for Monitor disciples, like ourselves, is to account for its sensitivity to the rate of change in interest rates regardless of absolute levels. For instance, an increase in 3-month treasury bill yields from an absolute level of 50 basis points to a level of 100 basis points can generate the same negativity for stocks as a scenario where yields move from 3.0% to 3.5%. This is symptomatic of much of the market commentary we hear today in the financial press when experts discuss the “rising rate environment”. Yes, rates are rising, but they also remain at historically low levels. The larger question, in our view, is if, and when, interest rates will climb to levels that are more competitive with the yields on stocks.
For additional perspective, it can be instructive to look at the spread between the earnings yield on the S&P 500 (the inverse of the Price/Earnings ratio) and the 10-Year Treasury Bond yield over time. Since 1969 the differential has averaged 0.78. It now stands near 3.0%, making stocks the heavy favorite. A common rule of thumb is that stocks need to deliver an earnings yield more than 100 basis points higher than the yield on short term (3-month treasury) paper to compensate investors for the risks associated with holding equities. Today, the earnings yield on the S&P 500 is well in excess of that level, and the above comparison illustrates favorable spreads to maturities further out on the yield curve. But the path of Fed monetary policy threatens to change that calculus, and the long end of the yield curve has been cooperative of late. Strong corporate earnings reports have helped keep spreads wide, but a future slowdown in corporate profit growth that coincides with increases in interest rates could shift the balance between equity and bond yields and tilt the Market Monitor towards negative territory. The current pace of earnings growth has been encouraging and suggests the status quo should hold. But asset allocators would be wise to keep an eye on corporate earnings forecast revisions for signs that the spreads between stock and bond yields are tightening.