The recent action in stocks explains why you can’t follow the narrative. It spins on its head and reverses itself constantly. Listen to the narrative and decide if it makes sense. The headlines have said stocks have risen and fallen based on the same news on inflation and yields. If you followed the media narrative that said stocks were going to sell off because of the increase in the 10 year bond yield, you got destroyed this week. The 10 year bond yield was near the recent high as it closed at 2.91% on Thursday while stocks increased again. The S&P 500 increased 1.21% and the VIX fell 0.67% to 19.13. The S&P 500 is down 4.93% since the peak meaning it reversed about half of its selloff while the treasuries didn’t reverse at all. I think the stock market selloff was caused by sentiment and a short VIX trade gone wrong. The increasing yields is a good thing because it signals growth is improving. Eventually higher yields will be a problem, especially for the deficit, but we’re not at that point yet.

The High Yield Spread Sometimes Doesn’t React To Corrections

Following my logic that the decline was based on temporary factors rather than the fundamentals, some investors are claiming the high yield spread not confirming the decline means there wasn’t risk of a bear market. While that sounds great because the high yield spread only widened 26 basis points, it’s not accurate to say that high yield bonds always sell off during corrections. As you can see from the chart below, there are a few other periods where stocks crashed and high yield bonds didn’t move. In the tech bubble burst of 2000, stocks fell 10.54%, yet the spread only widened by 2 basis points.

Everything Does Well With Rising Yields

The chart below is a death knell to the argument that stocks must decline when rates go up. As you can see, every style, market cap size, and sector of equities has positive performance when rates rise. This is because rising rates means higher growth. You can see that even real estate and utilities, which don’t like higher rates, have positive performance on average during these periods. The narrative that increasing yields means stocks will fall likely stems from the fact that bonds have been in a bull market for a few decades. Investors forget what rising yields mean. Secondly, investors are concerned with declining valuations. With earnings growth near 20%, even multiple compression can’t stop this market.

Finally, the chart shows information tech does the best with rising rates which is amazing because this sector is more important now than ever before. The titans of industry used to be firms like GE and ExxonMobil. Now the top firms are all tech with Apple, Amazon, Facebook, Microsoft, and Alphabet leading the charge. These firms are in new businesses and have also taken over traditional businesses as Facebook now produces content and Amazon owns retail stores.

Risk On When Yields Rise

Throughout history stocks have done well when yields went up and poorly when yields went down. This business cycle has been an exception to the rule as yields were low and stocks did well. This was a funny situation because some extreme bears claimed low yields were causing stocks to be in a bubble. For decades declining yields were a bad thing and all of sudden investors were blaming that negative catalyst for the bubble. The stock and bond markets are separate meaning regardless of where treasury yields are, these investors won’t buy stocks. If you are considering safe bonds, why would you buy stocks instead? Stocks are much riskier. Now that yields are rising, the bubble proponents have gotten louder, but they have egg on their face because stocks have continued moving up.

The chart below shows the cyclicals versus the defensive stocks when bond yields rise and fall. As you can see, the risk off trade has been in play when yields fall because the cyclical underperformed the defensive stocks. The results were better when yields increased. Eventually, when yields get too high you’ll see the Fed starting to aggressively fight inflation with rate hikes. When that occurs, there will be a decline in yields along with a recession. We’re not there yet. The yield curve suggests we have a few more years left in the recovery. It sounds crazy to say this recovery has a few years left because the cycle has gone on for a long time. However, it would have been a terrible idea to start selling stocks after the economy was in a recovery for seven years.

Home buying conditions weakening

The chart below shows the upper income home buying conditions compared with autos and large household durables. The chart aims to show the business cycle is ending because the buying conditions have fallen below the autos index. I think this indicator isn’t that great. As you can see in 1995, it seems like luck that the home index didn’t fall below the auto index. It’s generally bad when home affordability and auto sales are weak, but the comparison doesn’t seem valid. That being said, this is a great chart because it shows how the home buying conditions have already been weakening. It will only get worse when interest rates increase.

Conclusion

When stocks have a correction the financial media and investors throw everything at the wall and see what sticks. Literally anything could have been used as the blame for the stock market falling such as the outcome of the Super Bowl. The reality is the sentiment got too heated and the short VIX position imploded. Earnings growth is still strong, so stocks will regain their momentum and move up in 2018.