Bonds Will Determine Where Bear Market in Stocks Goes Next

The bear market in US stocks may be nearing the end of Act I (adjusting to higher interest rates), and many investors are looking ahead to Act II (adjusting to lower earnings.) But the transition is taking longer than anticipated, and some are questioning whether Act II is truly coming at all.

That’s reasonable, and that uncertainty could make for some compelling short-term rallies in a stock market that’s been beaten up.

Of course, the stock selloff in the first 10 months of 2022 has been driven mainly by the surge in Treasury yields, with the 10-year note rising to 4.23% on Thursday, the highest since 2008. As Valuation 101 taught us, the jump in risk-free rates increases companies’ cost of capital and boosts sovereign bonds’ relative attractiveness compared with stocks. Investors refuse to pay as much for the same cash flows, and price-earnings ratios shrink. Here’s how forward P/E ratios have tracked 10-year Treasury yields so far in 2022:

If yields rise, P/Es will still naturally sink, but the balance of risks for sovereign bonds is nowhere near as bad as it was a few months ago. Yields are already approaching levels consistent with relatively hawkish monetary policy. In other words, the P in P/E ratios may soon stabilize, based on interest rates alone.

That introduces Act II of the bear market: growth.