Higher Rates Test an Increasingly Narrow Stock Market

The S&P 500 earnings yield has been rising right along with the 10-year Treasury rate for a few weeks now. So the idea that the stock market is immune to rising rates isn’t really true. It just hasn’t been visible in price; it has been visible only through a falling PE ratio.

The other part of the equation, which matters as much if not more, is that implied volatility in the equity market remains low despite a steep rise in implied volatility in the bond market. Currently, the VXTLT is higher than the VIX index, and that doesn’t happen very often. In fact, as the chart shows, it has rarely happened over the past decade. The Fed minutes are due Wednesday afternoon, and I’m not sure that will be the day we see a course correction in this spread, but one of these markets is off base here.

The other piece is that the S&P 500 is no longer a valid proxy for the entire market. There used to be a time when the S&P 500 and the equal-weight S&P 500 traded pretty close to one another. In fact, the RSP even outperformed for a long time. That has obviously changed, and the rolling 3-month correlation between the RSP and SPY has fallen to its lowest level since 2024. The average stock is feeling the pain of higher rates, just not the biggest stocks that dominate the market-cap-weighted index.

Right now, financial conditions just haven’t tightened nearly enough to matter. Rates will need to stay at these levels for some time before the biggest impacts are felt, and that will have to come through a contraction of earnings estimates for the S&P 500 or a much more significant repricing of credit spreads. We just aren’t there yet. At the same time, it won’t be easy for stocks to rise materially further from here either. More stagnation is likely.

-Mike

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Glossary by ChatGPT

10-year Treasury rate — The yield on the U.S. government’s benchmark 10-year debt security, widely used as a reference rate for financial assets.

Credit spreads — The yield premium investors demand to hold corporate or other credit-risk-bearing debt over comparable risk-free government securities.

Earnings estimates — Analysts’ forecasts for a company’s or index’s future earnings, commonly used in equity valuation.

Earnings yield — Earnings per share divided by price, representing the inverse of the price-to-earnings ratio.

Equal-weight S&P 500 — A version of the S&P 500 in which each constituent receives the same portfolio weight rather than being weighted by market capitalization.

Financial conditions — The combined influence of interest rates, credit availability, asset prices, currencies, and other financial variables on economic activity.

Implied volatility — The market’s forward-looking estimate of potential price fluctuations derived from options prices.

Market-cap-weighted index — An index in which companies with larger market capitalizations receive greater weight.

PE ratio — The price-to-earnings ratio, calculated by dividing a security’s price by its earnings per share.

Rolling 3-month correlation — A continuously recalculated measure of the relationship between two assets’ returns using the most recent three months of data.

RSP — The Invesco S&P 500 Equal Weight ETF, which provides approximately equal exposure to each S&P 500 constituent.

SPY — The SPDR S&P 500 ETF Trust, an exchange-traded fund designed to track the market-cap-weighted S&P 500 Index.

VIX Index — The Cboe Volatility Index, which measures options-implied expected volatility for the S&P 500 over approximately 30 days.

VXTLT — The Cboe 20+ Year Treasury Bond ETF Volatility Index, a measure of options-implied volatility associated with long-duration U.S. Treasury bonds.

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