Market observers have been puzzled by a recent phenomenon. As bond yields rose last week, tech stocks underperformed. But some stocks that act like bond proxies have done the opposite of what might be expected: They are rising.
Since Wednesday’s close, the yield on the 10-year Treasury bond is up about 16 basis points. The S&P 500 is down 1.9 percent and the tech-heavy Nasdaq 100 is down about 4 percent.
But not bond proxies. Bond prices move opposite yields, but for these stocks, prices are on the rise.
Bond proxies
(since Wednesday close)
REITs (VNQ): up 0.5 percent
Utilities (XLU): up 3.3 percent
Consumer Staples (XLP): up 1 percent
There are a few explanations:
1. Flight to safety. These stocks are defensive plays, and in an environment when rates suddenly rise it would make some sense to hide in a Pfizer or Coca-Cola.
2. Reasonable valuations. If yields continue to rise, expect to hear more about the outperformance of value stocks over growth stocks. I know, it’s an old story. Growth has killed value for a decade, but this final interest rate push may finally tip the scales in favor of value.
For years, we had below-trend GDP growth and low rates. In that environment, you buy growth stocks (mainly technology) and dividend stocks. But we may be moving out of that era. We may be moving into an era of higher growth and higher rates. In that environment, owning value stocks may make more sense.
3. The strong economy helps all sectors. Take real estate investment trusts. Despite uncertainty around the retail and office space, other sectors that the REIT industry services, including health care, storage, apartments, even hotels, are all doing well. Occupancy rates are higher, and rents have generally been higher.
There’s also a fairly easy explanation for why technology has lagged the market in the last few days.
“Given their lack of dividends and high valuations, high-flying growth stocks are arguably the longest-duration assets in the world,” Morgan Stanley’s Michael Wilson told clients. “Therefore, it’s perfectly reasonable that they would eventually succumb to rising rates.”
Alec Young, a managing director of global markets research at FTSE Russell, agrees. “Fast-growing FANG names and momentum tech stocks use a discounted cash flow models to justify valuation,” he said. “Interest rate assumptions [are] critical to that.”
Does this mean the stock market is through for the year? Not necessarily: “People will look through the rate problem if earnings continue to be strong,” Young told CNBC.
But he did say that it might be healthy for the markets to tamp down any speculation that the Fed might get more aggressive: “It might be better for the markets if we got some softer economic data,” he said.
One thing’s for sure: A spike in rates has complicated the market outlook. It makes the path to move the markets higher more difficult.
What bulls need now, as we enter earnings season, is good earnings and good guidance. And they need the bond market to simmer down.
