Will the S&P 500 extend its record rally against rising yields and USD?

S&P 500 FUNDAMENTAL FORECAST: BULLISH

  • US stocks returned to ‘rally’ mode amid strong earnings, vaccine introduction and hopes for fiscal stimulus
  • However, a stronger US dollar and rising government bond yields could hold back the rally
  • The S&P 500 index is trading at a price-earnings ratio (P / E) of 31.6, well above the 5-year average

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Global equities are back in risk-on mode after a brief downturn in late January. Investor confidence seemed through strong corporate earnings in the fourth quarterand guidance, Covid-19 cases are declining and hopes Democrats can implement a major fiscal stimulus package soon. Renewed reflation hopes – expectations that demand and output will pick up with fiscal spending – have also led to the U.S. dollar strengthen in addition to rising longer dated Treasury yields, which could hinder the rally of the stock markets.

The DXY US dollar index and the S&P 500 index show a historically negative relationship with the past 12 months correlation coefficient stands at -0.892. This suggests that further strengthening of the greenback may put pressure on the S&P 500 index, as more than 40% of the index components’ income comes from abroad. A stronger US dollar simply translates into lower foreign sales due to exchange rate differences. For emerging markets, a stronger USD can also discourage capital inflows and hurt stock performance.

S&P 500 versus Dollar Index chart

Source: Bloomberg, Finance Prop

Longer-term US Treasury yields are rising and ahead of yield curve steeper further. Rising government bond yields make equities less attractive compared to government bonds, as the latter now appear to offer a better reward / risk ratio.

1 week changes in US Treasury yields

Source: Bloomberg, Finance Prop

Nevertheless an improved picture and fundamental robust corporate earnings in the fourth quarter can continue to stimulate stock prices. The labor market showed signs of improvement, with vaccine rollouts in recent weeks helping to rapidly reduce daily Covid-19 infections. The ADP number of private payrolls and the weekly unemployment claims figure both exceeded market expectations last week. The Fed’s commitment to one moderate attitude at the FOMC meeting in January alongside a similar tone of the RBA and BoE points to an extension of the current accommodative monetary environment. Against this backdrop, investors can be incentivized to put their money into riskier assets looking for returns and growth.

Fourth quarter corporate earnings have performed well so far, with more than half of the S&P 500 companies already publishing their results. Among those, 83% exceeded market expectations with an average positive earnings surprise of 20.3%. Major tech companies and banks were the main contributors to earnings growth, while the energy sector lagged. Encouragingly, more companies are spending positive EPS guidance for the first quarter of 2021, showing that business decision-makers are more optimistic about the recovery outlook and likely more willing to expand capex in the coming months.

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In terms of valuation, the S&P 500 index is trading at one 31.6 price-earnings ratio (P / E), the highest level in two decades and more than 50% above the five-year average of 21.0. A high valuation can make the index vulnerable to profit taking if rising returns and a stronger US dollar prevent stock markets from hitting higher highs.

S&P 500 Index vs. P / E ratio – 5 years

S&P 500 vs. price / earnings ratio

Source: Bloomberg, Finance Prop

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By Jonathan Prop

Jonathan Prop is an independent financial advisor. He has been working in finance for the last 20 years. After retiring early in his 40s, Jonathan decided to help others get to grip with financial markets, particularly his area of expertise - forex!

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