These are the days when equity traders envy their bond market brethren. They have a day off when we don’t. The same is the case on Columbus Day, not to mention the various days when bond markets close early before a holiday weekend. We wouldn’t want bond traders to suffer in traffic, would we? No, instead they get to create the traffic jams that the rest of us have to deal with. I know that the last refuge of the prejudiced is to say that “many of my best friends are…”, but many of my best friends are indeed bond traders and portfolio managers. That doesn’t mean I can’t be jealous of their schedule every now and then.
Yet on a day like today, the stock market gets to trade without the influence of its dour counterpart. That is impacting the trading dynamics we have seen in recent sessions, particularly the rotation out of high-flying tech stocks into smaller, more economically sensitive stocks. Remember, bond prices don’t usually benefit from economic growth (though they often do when you have a central bank relentlessly buying them). Think of how sharply Treasury yields rose earlier this week when the Pfizer (PFE) vaccine news was released. That news immediately improved the economic outlook, yet bond prices – which move inversely to yields – fell sharply. That doesn’t mean that bond traders are somehow unpatriotic (remember, they’re actually closed for a patriotic holiday) or rooting against economic growth, but they necessarily take a more sober view of the economy than stock investors.
Furthermore, not all sectors of the bond market are gloomy about economic prospects. Junk bond yields, as measured by the Bloomberg Barclays Index, hit a record low of 4.56% on Monday. These represent the most poorly rated corporate credits, meaning they are considered the most likely to default. Default is the worst fate that can befall a bond holder. Investors who buy bonds at face value are willing to forego capital appreciation for steady income. They care most about getting paid back. Not getting all they are owed is problematic. A strong economy helps companies with weak balance sheets, making them less likely to default. The record low yields imply a record likelihood of repayment.
There is a more subtle link between the bond and stock markets that stocks are exploiting today. In theory, if not in practice, stock valuations are a function of a company’s future discounted cash flows. As the level of interest rates decreases, the discounting factor increases. As rates have approached zero, stock investors have used that as a rationale for ever-increasing valuations in the highest-flying tech stocks. The rising rates that we saw recently acted as a damper on those valuations, causing some investors to reduce their relative weightings in tech shares. With the bond market closed, we have no negative input from interest rates. That is allowing a return to the speculation in tech stocks that drove much of this year’s rally.
We have mentioned on several occasions that the 6 highest valued tech stocks represent about 25% of the S&P 500 Index (SPX). If they rally, as they are doing today, they have no choice but to drag SPX higher. Without the bond market to provide a damper on valuations, the stock market is having some fun.
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