Rising Rates Are The Stock Market's Kryptonite

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The famous newsletter writer and market timer Joe Granville coined many a famous witticism in his time, many of them still in use today. His most famous one, “The obvious is obviously wrong,” eventually became the unofficial mantra of market contrarians everywhere. “As soon as you think you‘ve got the key to the stock market, they change the lock,” is another well-known Granville-ism.

While most of Granville’s bromides were pithy and (mostly) accurate, at least one of his oft-repeated observations missed the mark. At an investment conference many years ago, he once posed the following rhetorical question: “What do interest rates have to do with the stock market?” “Naaahthing!” was his sardonic answer.

With respect to the late, great market timer, I must emphatically disagree. Interest rates are in fact intimately related to the equity market and can have an outsized impact on the direction of stock prices. Don’t believe me? Then just look at what has happened to the equity market this year since bond yields began soaring.

A trip down the memory lane of recent history should suffice to further prove this proposition. In the months prior to the 20% stock market correction of late 2018, rates across the spectrum of Treasury bond maturities were on the rise on a steady basis, with the 10-year Treasury Yield Index (TNX) rising from 2.4% to over 3.2% (up 33%) in a 10-month period.

At the same time, the number of 52-week lows on both the NYSE and Nasdaq were elevated to exceptionally high levels for several months, led mainly by bond funds and other income securities. More than one market analyst dismissed the worrying rise of the new 52-week lows at that time by stating that bond funds should be ignored since they aren’t really stocks. Hence, there was nothing to worry about, they said.

They were very wrong. Eventually the strain of rising rates, coupled with the Federal Reserve tightening monetary policy, was too much for the broad equity market to bear. Stocks cascaded lower beginning in October 2018 and fell steadily into late December before finally bottoming out.

Fast forward to 2022. This time around, the 10-year yield has risen from 1.2% to over 3% in just nine months—up a stunning 150%—which is creating tremendous cross-currents and headwinds for stocks. Now, as in 2018, new 52-week lows on both major exchanges remain extremely elevated (well into the triple digits on most days) with rate-sensitive bond funds accounting for most of the selling pressure.

Already we’ve seen a formal “correction” (defined as a 10% or greater drop) in the S&P 500 Index and an outright bear market (down over 20%) in the Nasdaq Composite. Both events could easily be attributed to the negative impact of rising rates.

While both the S&P 500 and the Nasdaq have tried several times to bottom recently, the rate-related weakness has once again crept into the equity market in a growing number of sectors. The 5% pullback in the Nasdaq Composite at the time of this writing on May 5, led by several big growth-oriented names, has once again highlighted the negative impact of rising rates.

Meanwhile, the latest thrust to new highs in the 10-year yield index reflects the growing concern of many investors that a bear market could soon become established if rates continue along their present course.

BigCharts

A key reason why rising rates tend to be destructive for equity prices is due to the competition for investment funds from income-oriented participants. With U.S. government bond yields currently well above the average yield for the Dow 30 stock index, money is moving away from stocks and gravitating toward higher-yielding bonds.

WSJ, Author’s Chart

Historically, whenever the gap between 10-year bond and Dow 30 yields has widened in favor of bonds, stocks have tended to underperform. Hence my assertion that rising rates are the stock market’s “kryptonite.”

High-yield corporate, or “junk,” bonds are also in a precarious condition as prices have been persistently falling while yields rise. The SPDR Bloomberg High Yield Bond ETF (JNK) has been a reliable indicator for a major decline in stocks whenever the downward trend in JNK has been consistent for several months (as it was prior to the 2018 collapse). If the chart below is any indication, stock investors can expect above-normal volatility levels in the coming months.

BigCharts

There is, however, a chance that stocks can dodge the interest rate “bomb” if the rising rate trend quickly reverses in the near term. And while the bond bears are still very much in charge right now, there are some sentiment- and technical-related measures that suggest a bottom in bond yields (both corporate and Treasury) could occur in the next several weeks.

One of them is the McClellan Oscillator for the high-yield bond market has just soared to its highest (i.e. most oversold) level since the March 2020 crash. (This indicator examines difference between short- and medium-term moving averages of the net number of advancing junk bonds on a daily basis). As SentimenTrader’s Jason Goepfert recently observed, it just hit +75 for only the 3rd distinct time in the past 5 years last month, as the following graph shows.

SentimenTrader

And while this alone doesn’t guarantee a reversal for bond yields will happen, it does give the bulls a chance at recovering control of the short-term trend based on the apparent build up in short interest in the high-yield bond market. In other words, it likely wouldn’t take much to trigger a short-covering rally in bond prices (and a corresponding decline in yields).

For now, however, the primary evidence favors a defensive stance for equity market participants and holding off on making major commitments in riskier areas of the stock market. And until the rising bond yield trend reverses, the stock market will have a major headwind to contend with.