Donald Trump’s landslide victory has sparked a sharp jump in stock prices, fueling hopes that large-cap equities, after already posting huge gains this year, will continue to push to new highs. will In the nine days following the election, the S&P 500 gained more than 4% and hit an all-time high of 5,949 on Thursday, November 14. Even after the big decline at the end of the week, the big cap index is above 3. % since Trump won his landslide victory. The business press is buzzing with Wall Street’s high expectations for Trump’s agenda, which includes pro-business proposals such as cutting corporate income taxes and promoting a ramp in energy production. On November 18, the front page headline The Wall Street Journal “Investors are betting on a market meltdown,” Trump said. The story is about money being poured into equity funds at a rate rarely seen since the start of the Great Financial Crisis.
But the media and average people and money manager whales betting on the timing of the move are missing the largely overlooked story: the surprising, sudden rise in interest rates. This explosive shift, in the wrong direction, is sending the opposite message to the euphoria spread by Trump’s second-term prospects, a key long-term driver of stock returns. As Warren Buffett has repeatedly warned, bonds compete with stocks for investors’ money, and when ultra-safe fixed income delivers poor yields, stocks based on fundamentals can be overpriced. Well, bonds became very profitable overnight, possibly for worrisome reasons, and the outlook for equities got very bad. But for now, animal spirits are capturing the underlying fundamentals that, over time, inevitably lead prices.
The 10-year just posted its biggest sharp jump in history, which is a bad omen for stocks.
On Oct. 1, the 10-year Treasury bond rate, the fixed-income benchmark that has the biggest impact on equity valuations, stood at a very favorable 3.74 percent. The rate had fallen steadily from 4.64 percent at the end of May. Expectations of modest future yields kept a strong rally in stocks on track.
After that, that mischievous trend turned into a storm. As of Monday, Nov. 18, the 10-year yield had reached 4.47 percent, an impressive increase of 73 basis points in just six weeks. A big part of that jump happened after Election Day. This increase occurred in two parts: an increase in the “inflation premium” and an increase in “real output”. Neither is good for stocks. The “inflation premium” measures investors’ expectations for the average annual increase in CPI over the next decade. This component increased from 2.19 percent to 2.33 percent from the beginning of October. The takeaway: Investors are concerned that the Fed’s restrictive policies will take a long time to bring inflation back to their 2% target, and may even be lower. In any case, an increase in the inflation premium signals that the central bank may need to keep short-term rates high for an extended period. And any sign the Fed will stay tight, for much longer, is a curse for equities.
The second component, the upward trend in “real yields”, accounted for a larger share of the total increase, rising from 1.56% to 2.15% and contributing 59 points to the total increase of 74 bps. This is an even deeper warning than the possibility that inflation may prove more stable than expected. This is the “real” number that exerts the force of gravity on equity valuations. Inflation-adjusted yield rules as a so-called discount rate applied to the expected stream of future earnings to determine the “present value” of a company. This is a basic principle of financial analysis: the higher the discount rate, the lower the value of the dividend spread over the horizon, and therefore the less you should pay for the stock.
But the sharp rise in real yields hasn’t hammered share prices. In fact, markets rumbled as November 5 approached, then picked up another leg as Trump emerged victorious. The friction: It’s extremely low real rates that have provided the biggest tailwind to the two-decade-old bull market. From 2014 to 2022, inflation-adjusted yields averaged an unusually favorable 0.8%. The market clearly bought into the idea that real rates would remain low for years to come, justifying high PE multiples.
As of November 18, the PE on the S&P 500 stands at 29.4, based on the last four quarters of GAAP earnings. That’s a number you rarely hear from Wall Street, and it’s the biggest since the tech bubble burst in 2002, except for brief periods during the Great Financial Crisis and the Covid-19 outbreak. Earnings collapsed, artificially inflating multiples. At these fantastic prices, what edge do stocks offer over bonds? The expected return on equity is the reverse of this 29.4 PE, or 3.4%. The expected real return in 10 years is a real yield of 2.15%. So, stocks, the high-risk, volatile choice, especially at these prices, are showing a modest spread of 1.25 points over the most reliable Treasury bond. Compare that tight margin with the more than three times larger, 4.4-point cushion that equities enjoyed in mid-2021, when real rates were negative 0.3%, and the S&P’s PE was hovering at 24.6, its current Compared to about 30 of the surface is a relative bargain. .
Of course, bulls will argue that the explosion in earnings, courtesy of Trump’s deregulatory and tax-cutting program, will continue to propel markets. The math exposes this view as highly unlikely. Profits are already stagnating after a bubble that inflated between 2016 and 2021, when the S&P’s earnings per share exploded 110%. Over the past 11 quarters, EPS has grown only 2% overall, a number that outpaces inflation by a wide margin.
The big question is whether the jump in the real rate represents a structural change or just a shock that can quickly reverse as a ramp. We don’t know the answer. But it is very likely that the current nominal yield of around 4.5% over 10 years, and real rates of more than 2%, will remain within these limits for one simple reason: investors are bullish about large budget deficits of more than 6% of GDP. are worried about It can only get worse if Trump makes good on his pledge to cut taxes drastically. All we know is that the one force that has boosted stock prices over the past decade or so, ultra-low interest rates, has only done wonders about the face. The safest part of the market, U.S. Treasuries have been no match for stocks for many years. That scenario has completely changed. Perhaps that’s one reason why Buffett is going light on equities and buying US government bonds. Hopefully, math is no longer driving the markets. And in the end, it’s math that always wins.
