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US equity valuations increasingly 'irrational' as bond yield support evaporates

Falling bond yields facilitated a boom in U.S. equities in the aftermath of the massive market blow from the coronavirus pandemic. But as yields rise, the expected hit to stocks has yet to materialize as experts see market valuations growing to increasingly irrational levels.

The yield on the 30-year U.S. Treasury has climbed 56 basis points in 2021 so far to 2.21% as of Feb. 23 as investors bet on a combination of vaccine-fueled economic recovery and rising inflation. The S&P 500 broke a run of five-consecutive daily declines on Feb. 23 with a 0.13% upturn, but the index remains up 3.34% year-to-date.

Equity market sentiment has, in recent months, been supported by the rollout of vaccines and is expected to pick up in growth. But the support for historically elevated valuations has come from low yields.

The recent environment of ultra-low bond yields fueled "the greatest asset-price inflation of all time," according to Dhaval Joshi, a chief European investment strategist at BCA Research. But with yields rising on the expectation of improving growth and rising inflation, the stretched valuations of equities may be transforming from a "rational bubble" into an "irrational bubble" without a more significant pullback, Joshi said.

"I think we're flirting with irrational at the moment, though the behavior of the market in recent days suggests it wants to move back into the bounds of rationality," Joshi said in an email.

The forward price-to-earnings ratio of the S&P 500 — an important measure of valuation — has dipped to 22.72x as of Feb. 23 from 23.84x at the start of the year, but remains in territory not seen since the tech bubble at the turn of the millennium. The Nasdaq lost more than 75% of its value when that bubble eventually burst.

In normal circumstances, a fair valuation is around 16 times earnings. At a P/E of around 17x before the pandemic hit the U.S., stocks were already deemed expensive. The health crisis shook financial markets in March 2020, though stocks rebounded sharply as the Federal Reserve's commitment to unleashing trillions of dollars to scoop up government debt also caused bond yields to collapse.

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The yield on 30-year U.S. Treasurys fell from 2.39% at the start of 2020 to an all-time low of 1.17% on April 21, 2020, pushing yield-hungry investors into riskier assets such as stocks. As a result, the P/E ratio rose as high as 25.2x in July after falling to a nadir of 14.2x in March.

The impact of rising yields has been more keenly felt in gold prices which act as a pure-play on Treasury yields as the metal pays no dividend or interest. The Comex Gold futures price closed at $1,805.90 per ounce on Feb 23 after shedding 4.7% in 2021 so far and 12.3% since the peak of $2,058.40 in August, when bond yields were at their lowest.

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A number of analysts believe equities can potentially overcome a rise in yield, so long as the recent surge slows and economic growth is converted into strong returns.

"The equity markets might well be able to weather higher rates, but it will require a dramatic change in leadership," Timothy Edwards, managing director, index investment strategy at S&P Dow Jones Indices, wrote in an email.

The stretch in valuations has been led by technology, with Apple Inc. and Microsoft Corp. increasing their share prices by 73.19% and 41%, respectively, during 2020. The S&P 500's information technology sector, which includes Apple and Microsoft, returned 43.9% in 2020 as opposed to 18.4% for the broader S&P 500, according to S&P Dow Jones Indices. But as of Feb. 23, tech has returned just 1.8% so far in 2021.

"The tech-based, giant growth names that led U.S. equities up in 2020 are no longer leading the way up. Instead, broadly speaking, the current strength is from those that benefit more directly from the same ratcheting up in baseline domestic economic growth expectations that are pushing up the long end of the yield curve worldwide, and those sectors that don't mind inflation in hard assets like property and commodities," Edwards wrote.

Edwards expects stocks in the energy, financials, real estate and materials sectors that suffered in 2020 to rebound as restrictions loosen and the economy rebounds. The energy sector was particularly hard hit, returning negative 33.7% in 2020, while financials and real estate lost investors 1.7% and 2.2% respectively.

"Growth in bank loans, purchasing managers' index indicators and money supply trends could signal that the economy is transitioning towards corporate credit-driven growth and that conditions are in place for earnings growth, putting valuations at more reasonable levels," Amit Lodha, global equity portfolio manager at Fidelity International, wrote in a market commentary Feb. 22.

However, much of this potentially good news is possibly already baked into share prices. The S&P 500 has climbed 14.8% from 3380.37 to 3,881.37 as of Feb. 23 since yields began their upturn Oct. 1, 2020.

"Note that this multiple is calculated on the next 12 months of earnings, so it already incorporates a strong post-pandemic earnings rebound," Joshi said.

The current irrational valuation must "revert to rationality" through either declining stock prices, declining bond yields, or a sideways movement of both stock prices and bond yields while earnings gradually rise, Joshi said.

"I don't think that equities can survive a 2.5%-3% yield on the 30-year bond for long, but like the Wile E. Coyote running over the cliff-edge, the markets could remain in 'suspended animation' for a while," Joshi said.