Hurdles, risks emerge for stock indexes after rally

NEW YORK: Benchmark US stock index rallies, in anticipation of fiscal stimulus measures by the incoming administration of President-elect Donald Trump, could also be laying the seeds for equity market troubles from a stronger dollar and rising bond yields.
The S&P 500 stock index has surged over 8 per cent since the November 8 election, due in large part to sectors that are expected to benefit from an inflationary policy. The S&P financial sector has led the charge, with a gain of more than 17 per cent.
“We are putting fuel on the fire here potentially, because nothing has actually happened, everybody is acting like it is already happening,” said Richard Bernstein, Chief Executive Officer of Richard Bernstein Advisors in New York.
Those expectations, along with improving economic data and the US Federal Reserve’s recent decision to raise interest rates while signalling a quicker pace of hikes next year, have also served to strengthen the dollar and push bond yields higher.
It is the rising dollar that risks undercutting the earnings of large multinational firms, just when the overall earnings from S&P 500 companies were ending an earnings recession in the latest quarter.
And while rising bond yields may be beneficial to banks, they lift the overall cost of capital for companies and shrink the relative valuation advantage stocks have had over fixed income investments since the financial crisis.
“The thought is that earnings will be better and the economy is strong enough to be able to withstand higher interest rates, and that is why we’re not seeing a decline in stocks,” said Paul Nolte, Portfolio Manager at Kingsview Asset Management in Chicago.
“That being said, the stronger dollar and higher interest rates will at some point filter through to earnings. It’s just a matter of when and how.”
The dollar hit a 14-year high of 103.56 against a basket of major currencies following the Fed’s announcement on Wednesday. Stocks also appear to be getting pricey, with the current price-to-earnings ratio for the S&P 500 at 20.8, well above its long-term average of 16.6, according to Thomson Reuters data.
Higher bond yields is also increasing bonds’ attractiveness over equities. The S&P 500 dividend yield is 2.07 per cent versus a yield of almost 2.6 per cent for the benchmark 10-year US Treasury after its sixth straight week of gains.
“That is a big valuation disconnect, that will continue to keep people invested in bonds,” said Greg Peters, Senior Investment Officer at PGIM Fixed Income in Newark, New Jersey.
These twin challenges for equities could be mitigated, however, should the economy continue to improve. A climb in rates and the dollar are hallmarks of economic growth, provided the increases happen at a steady pace.
“This economy is in good shape in our view,” said Ryan Detrick, Senior Market Strategist at LPL Financial in Charlotte, North Carolina.
“So, rates are rising for the right reasons and the economy is proving that, and that should be a potential positive for equities.”
US STOCKS: The S&P 500 and the Dow were little changed in early afternoon trading on Friday, but the Nasdaq was dragged down by a fall in technology shares.
The Dow is on track for its sixth weekly gain and less than 1 per cent away from 20,000, a level it has never breached.
The Federal Reserve, which raised interest rates for the second time in nearly a decade on Wednesday, sees a faster pace of rate hikes in 2017, partly due to the potential economic benefits from President-elect Donald Trump’s policies.
US stocks have been on a tear since the November 8 presidential election, with the S&P rising 5.7 per cent on bets that Trump’s plans to deregulate sectors and increase infrastructure spending will boost the economy.
“We’re at a point where there’s not much to factor in,” said Mohannad Aama, Managing Director at Beam Capital Management in New York.
“You had the Trump rally, and then you had the anticipation about what the Fed was going to say.
For the next two weeks, we have somewhat of an aimless market, where people are getting ready to close the books for the year.”
However, there are some concerns that the “Trump rally” may have gone too far too soon and that valuations are stretched.
The S&P 500 is trading at 17.9 times forward 12-month earnings, above the 10-year median of 14.7 times, according to StarMine data.
At 12:34 pm ET (1734 GMT) the Dow Jones Industrial average was up 12.23 points, or 0.06 per cent, at 19,864.47.
The S&P 500 was down 1.19 points, or 0.05 per cent, at 2,260.84.
The Nasdaq Composite was down 5.88 points, or 0.11 per cent, at 5,450.98.
Eight of the 11 major S&P sectors were higher, with the utility index’s 1.37 per cent rise leading the gainers.
The technology sector fell 0.66 per cent, weighed down by Oracle and Intel, which fell 1.5 per cent fall.
Oracle dropped 4.2 per cent to $36.59 after the business software maker’s adjusted revenue missed analysts’ estimates. The stock was the biggest drag on the S&P.
Chipotle Mexican Grill rose 1.9 per cent to $389.83 after the company, under pressure from activist investor Bill Ackman, appointed four more members to its board.
Advancing issues outnumbered decliners on the NYSE by 1,856 to 1,026.
On the Nasdaq, 1,640 issues rose and 1,113 fell. The S&P 500 index showed 21 new 52-week highs and one new low, while the Nasdaq recorded 143 new highs and 24 new lows.— Reuters