All-Time Highs For Stocks—The Real Reason

Last week, the S&P 500 Index and the NASDAQ both hit all-time highs. And, a lot of investors are scratching their heads as to why.

After all, as readers of the Daily Pfennig® newsletter are aware, corporate earnings haven’t been that great. In the first quarter of 2016, year-over-year earnings were actually down 6.7%. So far in the second quarter, earnings are down 3.5% compared to last year’s second quarter.1 So, what gives?

The economy isn’t booming. As we pointed out last week, gross domestic product (GDP) growth in the second quarter was a big disappointment as the U.S. economy only grew 1.2%, which was well below Wall Street expectations of 2.6%.2

And, stocks aren’t cheap. Famed investor Warren Buffett’s favorite way of valuing the stock market is the Total Market Capitalization-to-GDP ratio. Based on that ratio, the stock market is now more overvalued than it was in 2007.3

So, why is the U.S. stock market hitting all-time highs? In order to answer that question, we need to look at what’s going on in the bond market.

It’s A World Of Negative Interest Rates
To understand, in part, what things are propelling stocks higher, you just have to take a look at bond yields around the world.

According to JP Morgan, 36% of all government bonds today are paying a negative yield.4 For example, if you buy a German Government bond maturing in 10 years, you’ll collect a yield of -0.11%.5 In other words, you’ll lose money if you buy the bond and hold it until maturity. Research from JP Morgan also shows that 74% of all government bonds are paying a yield of less than 1%.6

Some European banks are already studying the possibility of passing negative rates on to their customers by charging them interest on their savings. Dutch bank ABN Amro, for example, recently announced it could begin charging interest on business checking and savings accounts as early as October 1, 2016.7

How exactly do negative and low interest rates impact stocks?

Well, savers and retirees are struggling to find safe income in traditional investments. As a result, stocks are becoming a good alternative to generate income. The average monthly dividend yield of the S&P 500 Index for 2016, for example, is about 2.16%,8 which is much higher than what many government bonds are paying.

Here’s a good way to think about it…

If you were an investor looking for income, would you rather buy a 10-year Treasury bond with a yield of about 1.51%9 or shares of AT&T, which are currently paying a dividend yield of approximately 4.47%?10 That’s an easy answer.

If you want more proof of this classic chase for yield, you just need to look at the top performing sectors of the U.S. stock market this year. As you can see in the chart below (Figure #1), utilities have been the best performing sector so far this year. This is a sector well known for its high dividend yield.

Fig. #1
Top Performing Sectors Of The U.S. Stock Market
12/31/2015 to 8/5/2016

Source: Chart courtesy of Stockcharts.com. Asset trend data are illustrative only and do not reflect retail commissions or other transaction costs.

 

Other conservative investments that produce a reliable stream of cash, such as Real Estate Investment Trusts (REIT), have also done well. The Vanguard REIT ETF, for example, has a year-to-date return of about 18%.11

Is The Sky The Limit For The Stock Market?
Negative interest rates have been a direct result of central bank policies around the world. As long as central banks continue to drive yields into negative territory, stocks could continue to move higher.

Just look at what happened recently with the Bank of England (BOE.) Given all the uncertainties related to Brexit, the BOE recently announced an interest rate cut to 0.25%, the lowest rate in its 322-year history. It also announced a massive plan to buy government and corporate bonds.12

As of this writing, British Government bonds (known as “Gilts”) that mature in 10 years are yielding 0.53%.13 Not quite in negative territory yet, but with the additional buying pressure from the central bank, yields could continue to move lower. Of course, the London stock market rallied on news of the additional stimulus measures since any monetary tightening prospects were pushed well into the future.

Something similar is going on in the U.S. So far this year, the yield on the 10-year Treasury bond has dropped from 2.2% to about 1.51%.14 And, that low yield is making high-dividend stocks look very attractive.

In the end, if you want to understand why the stock market is reaching new all-time highs, the low-yield environment should be a part of the conversation. The bottom line is that despite weak growth and disappointing earnings, investors are still pouring money into stocks in a desperate attempt to find some yield. Will this keep the stock market moving higher even though traditional fundamentals aren’t exactly on solid footing? We shall see.

Until the next Daily Pfennig® edition…

Sincerely,
Mike Meyer
Vice President
EverBank World Markets, a division of EverBank
1.855.813.8484
everbank.com