Low Bond Yields for Longer Will Be Good for Stocks - Barron's

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Interest rates—and bond yields—will be low for at least the next several years, as Wednesday’s Federal Reserve statement made clear. That should be good for the stock market, James Paulsen, chief investment strategist at Leuthold Group, says.

In its latest statement and summary of economic projections, the Fed told investors that it would keep interest rates near zero until the U.S. economy is back at maximum employment and inflation looks set to run at an average of 2%, the central bank’s long-term target.

While Treasury yields rose after the statement, they declined on Thursday, with the 30-year yield down four basis points (hundredths of a percentage point) to 1.41% and the benchmark 10-year yield down two basis points to 0.66%.

Stocks fell as well, with the Nasdaq Composite’s 1.4% declines leading the way lower in midmorning trading.

Yet those declines may not last, if Leuthold’s Paulsen is correct. He says in a Thursday note that “the combination of extraordinarily low bond yields and the prospect of an earnings revival in the coming year provides an excellent foundation for the S&P 500, in general, and, in particular, its primary leaders—technology stocks.”

In the years since World War II, U.S. stock markets have performed best during months when Treasury yields were at their lowest (the bottom quartile), and second-best during months when Treasury yields were highest (the top quartile).

That may sound confusing at first, but economic growth is usually strong when bond yields are high, which boosts earnings and stock valuations. And according to Leuthold Group, stocks get the biggest boost when yields are high and earnings are rising. In the months since World War II when yields were highest, stocks climbed nearly 39% when the S&P 500’s earnings per share was rising. Stocks fell about 4% in months when the index’s earnings per share was falling.

Predictably, most of the time, stocks rose when earnings were rising and declined when earnings were falling.

But that rule doesn’t follow when bond yields are low. In those times, stocks rose 24% when earnings were rising—and stocks rose when earnings were declining as well, by an average of 11%, according to Leuthold. In fact, in months when earnings were falling and yields were low, stocks only declined ⅓ of the time, Paulsen found.

“Although EPS results are always important, they are not nearly as critical when bond yields are so uncommonly low, like today,” he wrote.

Part of the reason for that may be that earnings declines aren’t as frequent when yields are low. And either way, technology stocks have traditionally been outperformers when yields are low.

“In the lowest yield quartile, S&P [earnings] have fallen less than one-third of the time, compared to monthly declines of almost 40% in the middle two quartiles, and nearly one-half of the time when yields are in the highest quartile,” he said. “From the lowest-yield quartile, the excess return from tech stocks has been phenomenal regardless of the direction of S&P 500 [earnings].”

Write to Alexandra Scaggs at alexandra.scaggs@barrons.com

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