Donald Trump’s landslide victory has sparked a sharp jump in stock prices, and unleashed a wave of optimism that big cap equities, after already posting enormous gains this year, could keep pushing to new highs. In the nine days following the election, the S&P 500 surged over 4% to notch an all-time record close of 5949 on Thursday, November 14. Even after a big drop to end the week, the big cap index is still up over 3% since Trump clinched his overwhelming win. The business press is buzzing over Wall Street’s great expectations for the Trump agenda that incorporates such pro-business proposals as slashing the corporate income tax and fostering a ramp in energy production. On November 18, a front page headline in the Wall Street Journal trumpeted that “Investors are Betting on a Market Melt-Up.” The story related that money’s pouring into equity funds at a rate rarely witnessed since the onset of the Great Financial Crisis.
But the media and the average folks and money-manager whales wagering on flush times ahead are missing the big overlooked story: The shocking, sudden rise in interest rates. This explosive shift, in the wrong direction, for a crucial long-term driver of stock returns is sending exactly the opposite message from the jubilation spread by the prospects for a second Trump term. As Warren Buffett has warned time and time again, bonds compete with stocks for investors’ money, and when super-safe fixed-income provides puny yields, stocks, based on fundamentals, can be worth a lot more. Well, bonds just got far more lucrative overnight, for potentially worrisome reasons, and the outlook for equities just got a lot worse. But for now, animal spirts are swamping the bedrock basics that, over time, inevitably guide valuations.
On October 1, the rate on the 10-year treasury bond, the fixed-income benchmark that exerts the strongest influence on equity valuations, stood at a highly-favorable 3.74%. The rate had dropped steadily from over 4.64% at the close of May. Expectations that yields would remain extremely modest well into the future kept the powerful rally in stocks on track.
Then, that balmy trend turned stormy. By Monday, November 18, the 10-year yield had vaulted to 4.47%, a stunning increase of 73 basis points in just over six weeks. A big part of that jump happened following Election Day. The increase came in two parts: the rise in the “inflation premium,” and a waxing “real yield.” Neither one is good for stocks. The “inflation premium” measures investors’ expectations for average yearly increases in the CPI over the next decade. That component rose from 2.19% to 2.33% since the start of October. Takeaway: Investors are fretting that the Fed’s restrictive policies will take a long time to wrestle inflation to their 2% target, and may even fall short. In any event, the rise in the inflation premium signals that the central bank may need to hold short-term rates high for an extended period. And any sign the Fed will remain tighter, for longer, is a curse for equities.
The second part, the upward trend in the “real yield,” accounted for a much bigger share of the total rise, swelling from 1.56% to 2.15% and contributing 59 points of the 74 bps total increase. That’s an even darker warning than the prospect that inflation may prove stickier than anticipated. It’s the “real” number that exercises a gravitational pull over equity valuations. The inflation-adjusted yield reigns as the so-called discount rate applied to a company’s expected flow of future earnings to determine its “present value.” It’s a staple tenet of financial analysis: The higher the discount rate, the lower the value of those profits looming over the horizon, and hence the less you should be paying for the stock.
But the the real yield’s steep ascent didn’t hammer share prices. In fact, the markets just kept humming as November 5th approached, then took another leg up when Trump proved victorious. The rub: It’s extremely low real rates that have supplied the biggest tailwind to two-decade-old bull market. From 2014 to 2022, inflation-adjusted yields averaged an extraordinarily favorable 0.8%. The market clearly bought the view that the real rate would stay low for years to come, justifying high PE multiples.
As of November 18, the PE on the S&P 500 stands at 29.4, based on the trailing four quarters of GAAP reported earnings. That’s a number you’ll seldom hear from Wall Street, and it’s the biggest since the tech bubble ended in 2002, except for brief periods during the Great Financial Crisis and Covid-19 outbreak where earnings collapsed, artificially inflating multiples. At those sumptuous valuations, what edge do stocks offer over bonds? The expected return on equities is the inverse of that 29.4 PE, or 3.4%. The expected real return on the 10-year is that real yield of 2.15%. Hence, stocks, the high-risk, volatile choice, especially at these prices, are positing a measly spread of 1.25 points versus the super-reliable treasury bond. Compare that narrow margin with the over three times bigger, 4.4 point cushion that equities enjoyed in mid-2021, when the real rate was negative 0.3%, and the S&P’s PE hovered at 24.6, a relative bargain compared to its current level of nearly 30.
Of course, the bulls will argue that an explosion in earnings, courtesy of the Trump deregulatory and tax-lowering program, will keep propelling the markets. The math exposes that outlook as highly unlikely. Profits are already stagnating following a bubble that grew between 2016 and 2021, when S&P earnings-per-share exploded 110%. In the past 11 quarters, EPS has risen only 2% overall, a number that trails inflation by a wide margin.
The big question is whether the leap in the real rate represents a structural shift or a mere blip that could reverse as fast as it ramped. We don’t know the answer. But it’s highly possible that the current nearly 4.5% nominal yield on the 10-year, and well over 2% real rate, will stay in those ranges for a simple reason: Investors are getting increasingly worried about gigantic budget deficits exceeding 6% of GDP that can only get worse if Trump delivers on his pledge to radically slash taxes. All we know is that the one force that more than any other has boosted stock prices over the last decade or more, extremely low interest rates, just did an astounding about face. The safest part of the market, U.S. treasuries, offered no competition for stocks for many years. That scenario’s totally changed. Maybe that’s one reason Buffett is lightening up on equities and buying U.S. government bonds. Hope not math is now driving the markets. And in the end, it’s the math that always wins.
