All else equal, a lower risk-free rate implies a lower cost of capital. As a result, equities should be worth more. In general, this is reflected in a company's interest expense (the cost of preferreds may also be impacted). Since the recession, long-term yields ( TLT, IEF, TLH) have been on a downward tear.
(click to enlarge) Quantitative easing was no doubt a major contributor to this trend. By entering the market as a large buyer, the Fed artificially increased the demand for bonds, leading to lower yields. It worked marvelously, as the S&P 500 (NYSEARCA:SPY) more than doubled in the following years.
(click to enlarge) In addition to cheaper debt which directly contributed to the bottom line, corporations also took advantage of lower rates and increased buybacks to increase return to shareholders (i.e. higher EPS). This improvement in fundamentals justified the rally.
But even after QE ended in 2014, long-term yields continued to decline, and the trend accelerated in 2016 as we entered a year of uncertainty (e.g. oil troubles, now Brexit).
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However, you may have noticed that declining yields have not contributed to a major rally. Since 2015, the S&P 500 has appreciated by a measly 1.74%. Why is this the case?
I believe that a major reason is simply fear. Investors don't like uncertainty, so they pile into safe haven assets even before a potential crisis happens. While the bears worry about a potential downturn that may or may not materialize, corporations will benefit in the meantime. We know that lower yields will generate tangible benefit for corporations because credit spreads have declined as well, so the effective yield (i.e. cost of debt) has lowered for most corporations (distressed companies aside).
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Out of all of the major sectors, utilities outperformed the market by the biggest margin. This isn't surprising since they are treated as defensive stocks. But what about other sectors? It's not like utility stocks are the only ones benefiting from a lower cost of debt.
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In the chart above we can see that utilities, consumer staples, and REITs were the outperformers, whereas the rest only gave lukewarm performance or depreciated. Performance for certain sectors like financials and energy can be explained through fundamentals (lower interest rate margins and lower commodity prices), but other sectors should have appreciated more.
For example, industrial companies are often leveraged, allowing them to capture more benefit from a lower cost of debt; but they received no love from the market, despite the fact that TTM EPS for the sector has risen 31%. Similarly, EPS for the consumer discretionary sector grew 12.6%, but no credit was given as well. In contrast, utility sector's EPS only grew by 3.7%. This is evidence that investors are not investing based on the underlying the fundamentals, but are buying safe assets as a cure for their doubts about the economy instead.
Surprisingly (or unsurprisingly, depending on your perspective), REITs have fared very well. Like utilities, REITs are leveraged investments, so a lower cost of debt will benefit them tremendously (also increases book value). However, this line of thought directly contradicts with the idea that the economy will perform poorly in the near future (i.e. why yields are low in the first place). We all know what happened during the last recession. Property prices will plummet if the economy collapses (as will other industries), but somehow investors view REITs differently from the rest of S&P 500's constituents.
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If we ignore fundamentals and try to think like the market, a possible explanation could be that investors are blindly chasing yield. This would explain why investors are piling into REITs despite their potential to blow up during a market downturn.
Lower yields have brought tangible benefits to corporations. However, only utilities, consumer staples, and REITs captured the market's attention. Companies outside of these sectors (except financials) will benefit from lower yields as well, but fear in the market is artificially depressing their valuation. This bias is readily reflected the discrepancy between sectors' earnings growth and their recent performance.
Of course, just because the index is attractive now , it doesn't mean that it will remain cheap. Interest rates are a "market risk" that investors have no control over. It is possible that rates will rise once again in a couple of months, increasing corporations' cost of capital and lowering their valuation. I have no opinion regarding the future movement of interest rates in absence of major catalysts such as QE; but given the present situation, I believe that the S&P 500 is artificially depressed as the result of widespread doubts about the economy, however unsubstantiated they may be (read Don't Be A Contrarian).
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