Examining Some Pat Narratives

Examining Some Pat Narratives

By MICHAEL SANTOLI | MORE ARTICLES BY AUTHOR

What do Treasury yields, inflationary expectations, personal tax rates and profit margins really say about the stock market?

The investment business traffics in too many pat stories and unexamined assertions. Note all the spreadsheet-enabled dividend-discount models purporting to arrive at the perfect price for a stock, inter-market relationships held to be as inexorable as celestial movements, "important" technical-index levels taken two places beyond the decimal point.

So let's complicate a few of the common Wall Street narratives in the context of today's market action.

Rising Treasury-bond yields are a danger to stock prices.

Not from these low levels. That higher government-bond yields (up to 2.3%, versus 2.04% last week on the 10-year note) are a problem for equities is a notion that's gone more than halfway from quaint to hoary. In fact, Treasury rates and stock indexes have risen and fallen together more often than not in recent years, given that lower yields have meant higher risk-aversion, economic weakness and deflation fears. The first time the Standard & Poor's 500 hit 1400―which it reached again Friday―in 1999, the 10-year Treasury was at 5.7%.

More immediately, the selloff in Treasuries last week came as the Federal Reserve failed to foreshadow another potential program of buying securities with conjured money―something not to be wished for among stock investors. Besides, approximately zero investors wake up each day and, over breakfast, decide between buying government debt or equities. HSBC strategists figure that rising Treasury yields don't start to work against stocks until they reach 4%.

Higher inflation expectations, which have recently been evident, should compress stock valuations.

This has some historical legitimacy, but it hasn't held since 2008, says strategist Michael Darda of MKM Partners. Climbing inflation expectations at this point suggest a drift toward normal, rather than an overheated stampede of price increases. As with interest rates, inflation rising is OK until it becomes a genuine problem, but this remains a way off.

The prospect of higher personal-tax rates will undercut stocks as investors come to recognize the threat.

History shows that tax changes rarely hurt the market at large. Keith Lerner, strategist at SunTrust banks, calculates that there is little discernible economic or market impact of higher marginal tax rates.

Since 1930, the average stock-market return in years when the top marginal tax rate rose at least three percentage points was 14.4%, Lerner found, and the performance in the year prior to the hike was 12.6%, so there was no selloff in anticipation, on average. Curiously, the average return in years when rates were cut was lower, at 10.7%.

Corporate profit margins, now at a historic peak, are due to erode, hurting the fundamental case for equities.

Margins certainly do look toppy. Yet the return on equity of Standard & Poor's 500 companies―defined as earnings divided by book value―is not at a peak, and in fact is not vastly above its historical average. This is because the cash-rich corporate sector has record book value, according to quantitative strategist Joe Mezrich of Nomura Securities. So if companies can continue to make progress in squeezing a bit more return per dollar of balance-sheet fuel, these levels of profitability can withstand gravity for a while longer.

ALL OF THIS TOGETHER DOES MORE to explain and justify the relentless strength of stocks so far this year, rather than offering a high-conviction case that the market is set to speed onward and upward from here.

The key measures of the tape continue to favor eventually higher index levels, with perhaps an imminent pause or gut check, as many of us have been anticipating for weeks now. Underinvested institutions have finally quit fighting the levitation in equities. Oil prices have calmed a bit. The market has been animated by stock- and sector-related stimuli rather than macro drama, rotating here to there without either melting up or down with every press conference in Brussels.

Still, some mechanical influences related to rampant downside hedging have suppressed volatility into Friday's options expiration, an effect now lifted. Quarter's end awaits, with its standard potential for repositioning and chip cashing. Corporate insiders, more an atmospheric reading than an acute timing tool, have been eager sellers lately. High-yield bond spreads have quit improving, for the moment. Ned Davis Research's market handicapper Tim Hayes, who has correctly kept clients on the bullish side of things for many months, last week suggested that at least a consolidation should arrive before too long. And what's with this overplayed comparison of the U.S. market to the "best house in a bad neighborhood"? Isn't that exactly what smart real-estate agents tell you not to buy?

All this points to a market in search of some excuse to jolt complacent bulls, but not to bring this bull market to an imminent or dramatic close.