Stocks Come Off Another Dreadful Week On Rising Bond Yields, But Further Downside Could Be Limited

U.S. equities come off another dreadful week on rising bond yields, which turned risk trades off on Wall Street. But the downside from here could be limited as valuations become reasonable.

The S&P 500 ended last week with 90 points or a 2% loss, the Dow Jones with 1,200 or a 3.4% loss, and the tech-heavy Nasdaq with 337 points or a 2.5% loss.

The benchmark 10-year Treasury bond yield spike, which overshadowed solid earnings from Walmart and Applied Materials, spooked equity traders and investors. It now stands at 4.25%, up from 4.16% last week and 2.87% a year ago.

That's due to resilient economic growth, a tight labor market and a still elevated core consumer and producer inflation. They make the case for further interest rate hikes by the Fed.

"While inflation appears to be finally settling down, there's been no real respite when it comes to interest rates," Jason Mountford, trend analyst at Q.ai, told International Business Times. "Thirty-year fixed mortgages hit their highest level in 21 years this week, rising to 7.09%. U.S. Treasury yields have also spiked, hitting their highest level in almost a year, and the probability of further hikes from the Fed is slowly increasing."

Oliver Rust, head of product at independent inflation data aggregator Truflation, doesn't see an end to interest rate hikes either.

"Overall, it is clear there is some way to go before inflation is under control and we see an end to U.S. interest rate hikes," he told IBT.

He believes today's markets seem only to be disillusioned, as they are still looking "for interest rate cuts and lots of free government money as a cause to celebrate."

Rising U.S. Treasury bond (T-bond) yields are a big negative for stocks.

First, they make T-bonds more appealing than stocks to investors seeking income and credit risk protection.

Second, T-bond yields are critical in almost every equity valuation model. For instance, they are the discounting factor in the present value model, meaning they drive valuations lower anytime they rise.

Third, rising T-bond yields drive all other long-term interest rates higher, including mortgages, which are already at multi-year highs. As a result, they hurt the interest rate-sensitive sectors of the market, like the housing sector. Thus, there were significant losses in housing stocks last week.

Fourth, rising interest rates make it harder for heavily indebted companies to re-finance their debt, raising the prospect of corporate failures.

Wall Street tasted such failures last week when Evergrande Group, China's top-selling developer, filed for bankruptcy protection.

This high-profile failure raised the prospect of a contagion and another financial crash and global recession. It was another reason to turn risk-off trades on Wall Street, sending investors into the safety of money market funds like U.S. Treasury bills.

Still, Sam Caylor, senior trader and investment analyst at Vineyard Global Advisors, sees equity valuations heading pretty much the same from here.

"In a fair value model created by VGA that explores the relationship between treasury yields and S&P 500 Index Earnings, the estimated present fair value of the S&P 500 is approximately 4,375," he told IBT.

"Even if the 10-year yield were to rise to 4.5% or 5.0%, the fair value model only decreases to 4,330 or 4,220, respectively," he added. "That represents only a 3% to 6% additional downside, with a Price to Earnings (PE) multiple of 18x. While much of the narrative around higher rates has been tilted negative for equities, our models show that further downside could be limited to single digits."