Insider

A CIO who earned up to 90% per trade during last year’s crash is now warning of a potential 20% crash in the S&P 500 by the end of March as 10-year Treasury yields continue to rise

Summary List PlacementYields on 10-year Treasury notes have spiked to a one-year high over the last month, rising above 1.5% as COVID-19 cases fall and vaccinations continue — positive developments for the economic recovery ahead.  The surge has spooked equity investors, who sold off mega-cap tech stocks this week and...

A trader on the New York Stock Exchange looks at stock rates 19 October 1987

Summary List Placement

Yields on 10-year Treasury notes have spiked to a one-year high over the last month, rising above 1.5% as COVID-19 cases fall and vaccinations continue — positive developments for the economic recovery ahead. 

The surge has spooked equity investors, who sold off mega-cap tech stocks this week and dragged the S&P 500 down 1.4% and the tech-heavy Nasdaq 100 down 3.4%.

According to James McDonald, chief investment officer of the alternative asset manager Hercules Investments, the bleeding isn’t likely to stop anytime in the coming weeks.

That’s because higher bond yields can start to pull investors looking for a certain level of returns away from stocks — a headwind for equity markets, particularly for the most highly valued growth names. Yields rise when demand for bonds fall. And this week, the bond market quaked at signs that the economy’s recovery would be strong enough to lift inflation and Fed-administered interest rates.   

“Treasury rates are far too low given the growth expectations,” McDonald told Insider on Friday. “And growth expectations, we think, are reflected in forward-looking price-to-earnings ratios that reflect the most recent all-time stock market highs.”

While he can’t be certain on when and by how much yields will rise, McDonald said an increase to around 2.5% for 10-year notes, a move of about 1%, is possible by the end of March. As such, McDonald has a dim outlook for equity markets, as rising Treasury yields will continue to repel investors from stocks.

He said if 10-year yields do rise another 1%, he expects a 20% drop in the S&P 500 and a 25% drop in the Nasdaq 100.

“We think there’s an inevitable correction,” McDonald said. “Right now rates are priced for a higher equity risk premium, and so we think a 1% increase in 10-year yields…it’s going to slash S&P multiples by 18%…and then Nasdaq 100, we think it will cut the P/E multiples by 22%.”

He profited handsomely during the market’s crash last March, earning up to 90% per trade on out-of-the-money call options he had bought on volatility-linked ETFs. 

McDonald said he expects the next sell-off to be driven by the tech stocks at the top of the market and by small-cap stocks, which have seen steep appreciation in recent months. The Russell 2000 index is up 40% since the beginning of November. 

He warned that inflation poses the biggest threat to the market. Inflation expectations are reflected in bond yields, and as inflation expectations rise, investors demand higher yields to compensate.

With the huge fiscal and monetary stimulus undertakings over the last year and going forward, and as the low interest rate environment allows economic growth to run hot, many expect inflation to rise in coming years. And because inflation has lagged in recent years, the Federal Reserve has also said they will permit inflation rates to rise above 2% in the years ahead.

TINA: There Is Now an Alternative

While there may not be consensus on how much of a hit stocks will take, others share McDonald’s expectation that Treasury yields will continue to rise and hurt equities. 

A popular argument in justifying equity valuations has been that “There Is No Alternative,” or “TINA,” since bond yields have been so low. While the trajectory of bond yields is still uncertain, that argument looks to be changing now. 

Bank of America’s top equity and quantitative strategist Savita Subramanian has made this point. In a recent note, she said that the bank estimates 10-year Treasury yields will reach 1.75% by the end of 2021, threatening stocks. 

“Stocks continue to look more attractive relative to bonds, with the S&P 500 dividend yield still above the 10-year yield,” Subramanian wrote in the note. “But our house view of 1.75% in the 10-yr yield by year-end suggests the long-standing ‘There is no alternative’ or TINA mantra may be at risk.”

At the same time, the Fed has committed to a “whatever it takes” approach in their quantitative easing efforts. As such, the central bank could take steps at some point to further pin down yields and therefore prop up equities, though it’s unclear when, if, and to what degree they would do this.

Still, yields have room to run the months ahead, it appears. And if they run too far — whatever point markets deem that to be — investors ought to be prepared.

SEE ALSO: MORGAN STANLEY: Buy these 14 infrastructure stocks now as Congress gets ready to pass a deal later this year — including 8 that could rise at least 55%

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