Why Is the Stock Market So High? Ask the Bond Market


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CreditMinh Uong/The New York Times

The American stock market has reached new highs this summer for some unsettling reasons.

Since the sharp decline set off in late June by the British vote to leave the European Union, stocks have recovered smartly, reverting to an upward trend that has prevailed since 2009. That wasn’t unexpected: Relief rallies often have occurred after market shocks.

This time, though, many of the factors that typically propel a rising market are absent: Corporate earnings aren’t strong, the economy isn’t booming, and stock prices aren’t cheap.

None of those fundamental indicators have been auspicious, but it hasn’t mattered because the fuel that is making the stock market soar seems to be coming from outside the stock market entirely.

In fact, it appears that we need to thank the bond and foreign exchange markets for providing the underpinnings for the stock rally.

Bonds have risen sharply in value, and their yields, which move in the opposite direction, have plummeted. That has made stock prices look cheap and dividends generous. The average dividend for the Standard & Poor’s 500-stock index is about 2.1 percent — much higher than the yield on a 10-year Treasury note. Many investors have moved to stocks in search of a better deal.

That has helped make stocks rise, even though stock valuations aren’t particularly appealing after seven years of price increases.

“On a historical basis, the overall stock market has become expensive, but not relative to bonds,” said David A. Rosenberg, chief economist and strategist at Gluskin-Sheff in Toronto. “People have been looking in the stock market for yield, in the form of dividends, because the bond market has become so expensive and bond yields have gotten so low.”

That’s part of the story. But there’s more. Not all parts of the stock market are being affected in the same way. Another factor, the strong dollar, has made stock sectors that are fairly impervious to exchange-rate shifts especially attractive. When foreign earnings in, say, euros or pounds translate into fewer dollars, American stocks with predominantly domestic revenue streams usually benefit.

That’s why many American utility and phone company stocks — which both pay high dividends — have been soaring.

“These stocks have hit a sweet spot,” said Craig Moffett, a senior analyst at MoffettNathanson, who focuses on telecom companies, including Verizon, AT&T, T-Mobile and Sprint. As a group, telecom companies have far outpaced the market as a whole, even though Mr. Moffett is skeptical about the prospects for the sector’s stocks. Many of them are overvalued, he says.

“As an analyst, it’s frustrating,” he said. “It doesn’t seem to matter what the specific issues are for these companies as businesses. Their stocks at the moment are trading for other reasons: interest rates and the dollar.” He has found a strong correlation between these factors and telecom stocks.

“At the moment,” he said, “interest rates and exchange rates outweigh the stock fundamentals.”

Stock investors, therefore, may want to seek guidance from these markets, especially the bond market, which has moved into historically unusual territory.

The 10-year Treasury note, for example, has had an average yield of more than 6 percent since 1965 but has fallen to less than 1.5 percent today, and that counts as a solid yield in the current global market. More than $13 trillion in government bonds around the world carry negative yields, a concept that is difficult to grasp. Buy a bond and you will lose money — unless yields drop even further into the negative zone, driving up bond prices.

Negative yields attest to severe global economic weakness. Central banks have held interest rates low to try to stimulate the economy, and with inflation at very low levels, bond investors have accepted minuscule or negative yields. Still, among the world’s major economies, the United States is perhaps the strongest now, and the Federal Reserve signaled on Wednesday that it remained open to a rate increase this year.

Market prices suggest that a rate increase won’t occur before December, especially with a presidential election looming in November. But other central banks have been moving toward even more expansive monetary policies, adding luster to the dollar and hurting returns of American companies with major overseas revenue streams.

Given those realities, investors hungry for better returns and higher yields have been flocking to the American stock market, especially to high-dividend-paying, low-foreign-revenue utility and telecom stocks. Both sectors have risen more than 20 percent this year.

The current interest rate and exchange rate alignment may well persist for a good while, but there are no guarantees. A recession, a surge in inflation, an unexpected rise in interest rates or a major political shock or natural disaster could wreak immediate damage. And interest rates and inflation have rarely remained at today’s low levels for very long.

Mr. Rosenberg therefore suggests that investors begin to hedge against these risks by diversifying with inflation-indexed bonds, gold and some reasonably priced stocks in sectors like railroads, automobiles, banking and construction.

Mr. Moffett is certain that at some point, the usefulness of his kind of detailed stock analysis will be restored.

“Many of the valuations in the market don’t make sense right now in isolation,” he said. “The risk for investors is that if interest rates start to rise, stock prices could start to shift almost overnight. That may not happen soon, but eventually it will happen. And for a lot of people, that won’t be a very pleasant moment.”

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