By Ketki Saxena For years, investors have been warned about the dangers of rising bond yields. Many believed that higher interest rates would be detrimental to stock market performance, but is this really true? In reality, there are many factors at play when it comes to stock market trends.
One common misconception is that stocks and bonds compete for the same pool of funds. However, this oversimplifies the complex relationship between these two asset classes. While conventional wisdom suggests that stocks should offer a higher earnings yield than Treasury bonds in order to justify their volatility, real-world data tells a different story.
Over time, businesses grow and innovate, leading to increased earnings even after adjusting for inflation. This means that while profits can fluctuate wildly in response to economic cycles and other external factors, they tend to trend upwards over time. Additionally, because analysts' projections often skew lower during times of uncertainty or poor performance in recent history (due largely to human nature), forward-looking metrics like price/earnings ratios may not always accurately reflect future earnings potential.
Despite what some may believe about rising bond yields being bad news for stocks - historical data shows otherwise. For example: During the 1980s and 1990s in the United States where 10-year U.S Treasury yields topped at more than 4%, US stocks still soared by up to 400%; similarly, Canadian markets saw an increase as well despite high bond yields averaging roughly above 7%.
Stock returns aren’t capped by coupon rates like bonds held until maturity. Instead, they benefit from economic growth with no ceiling or limit on earning potential which can also include dividends paid out if management foresees future growth. They can borrow money to buy back shares and retire them, which increases earnings per share and returns. This is happening now in the market, but it's largely unseen due to the focus on rising bond yields.
Furthermore, while inflation expectations are reflected in bond yields, companies have more flexibility when it comes to passing on cost pressures than bonds do with coupon rates. Stocks tend to fare better over time as a result of this added flexibility. While stocks may have dipped during periods of high inflation last year (mostly driven by sentiment), gross profit margins for S&P 500 and Canadian companies remained relatively stable throughout 2022 at around 33% and 27.3%, respectively.
Overall, while interest rates certainly play a role in economic performance - they don't necessarily dictate stock market trends as many believe they do. Currently, he correlation between Canadian stocks and 10-year bond yields is only about .17 indicating that there isn't much lockstep movement or opposite movement between these two asset classes.