Stocks rebounded sharply this week, with the S&P 500 back to all-time highs and the NASDAQ recouping a significant share of losses from the selloff. Treasuries gained as yields fell, with the inflation reading coming in weaker than anticipated and investors scooping up bonds with higher, more attractive yields. The $1.9 trillion recovery package was passed by Congress and is expected to be signed into law this week, adding a significant boost to the economy, and providing enough support to eliminate the output gap from the COVID pandemic in the US. The underlying fundamentals of the economy meanwhile, are showing signs of strength, with weekly jobless claims dipping more than forecast and job openings rising to the highest level in nearly year.
Beneath the surface of the equity market, significant moves have been underway this year. The over 10% pullback in technology stocks has been largely attributed to rising bond yields, which make the anticipated higher future cash flows of growth stocks less attractive when current rates are higher. On the flip side, other sectors of the market benefit from rising yields, such as banks and those companies that should see significant growth in cash flows sooner rather than later. This growth to value shift has accelerated in recent weeks, and the divergence can be witnessed starkly by the performance of the more value-style driven Dow Jones Industrial Average and the growth-oriented NASDAQ indices. With much of the recent froth in markets attributed to tech and growth names, the pullback was not entirely surprising, and considered healthy to some degree. However, a sharp reversal has since ensued. We expect that the shift from tech to other beaten-down areas of the economy will continue, as the reopening of the economy and the stimulus efforts out of Washington should more acutely benefit industrials, financials, and other cyclical areas of the market in our view. The biggest threat to the direction of travel of equities remains moves in bond yields, which we believe could cause a significant pullback if they continue to rise rapidly. Recently, the 10-year yield on US government bonds surpassed the dividend yield on the S&P 500, reducing the relative attractiveness of equities from an income perspective. If bond yields were to move up to 2%, we believe equities would face serious vulnerabilities, as the equity risk premium, the earnings yield of the S&P 500 over Treasuries, would be close to the lowest levels seen since the Global Financial Crisis. Low equity risk premium levels have tended to presage downturns in the equity markets, and for this reason we will be closely monitoring bond yields for further signs of stress ahead, particularly from the Fed, inflation data, and bond demand.
We took advantage of last week’s selloff by adding to both equities and bonds, as opportunities became available. We believe that the economic reopening, coupled with trillions of dollars of unspent cash on the sidelines and a Federal Reserve remaining supportive, provides a backdrop that should support risk-taking. While volatility could likely remain elevated for the foreseeable future given the significant cross currents facing investors, price drops should be seen as opportunities to rebalance. As always, we continue to remain extremely focused on monitoring unfolding market dynamics and reacting only when appropriate. Please feel free to call our office with any questions you may have.