Published January 09, 2013
With all the data immediately available to all of us, the importance of some tend to get lost, while other data points that aren't that relevant often get highlighted. So, what statistics should investors watch with a keen eye is always up for debate - should it be unemployment numbers, GDP, CPI, PPI, manufacturing numbers, etc.?
Yes, they are all important numbers, but the one key “statistic” to watch is the 10-year Treasury yield. The move of this impacts the entire investment world more than just about any other piece of data. Investors are convinced that the almighty government has power it doesn't, and public opinion is that interest rates are going to remain low, since the Fed has said so.
Well, news alert -- the Fed only can directly influence the fed funds rate and discount rate (these are short-term interest rates). The Fed has very little impact on effectuating longer-term rates, including the 10-year Treasury.
This is crucial for investors to understand because when portfolio managers and research analysts are evaluating the valuation of stocks, they use the 10-year Treasury as a major part of their formula. When the 10-year yield is extremely low, the acceptable price/earnings ratio for stocks tends to be higher.
When rates start to rise, the stock market has historically rallied for a period of time because this has usually signaled a strengthening of the economy. However, historically you will see that after a 100- to 150-basis point rise in longer-term rates, valuation models suggest that lower P/E ratios are the norm. Meaning, you will see a shift in asset allocation models by many firms suggesting that valuations are not as attractive for stocks as they were when rates were lower. At that point you will see headlines saying that stocks may be "overvalued” (this obviously depends on how earnings come in.)
Bottom line, there are about 55 factors we use in evaluating stocks to determine if they are over-valued or under-valued. The 10-year is not the only factor analyzed, but it is certainly in the top five. It drives me crazy when people believe that this rate will remain low because the "government" says rates will remain low.
The purpose of this article is simply to drive your attention to the fact that the government's power is limited to rates that do not directly impact the valuation of stocks. The 10-year Treasury rate is rising very quickly, and due to quantitative easing and many other factors, I expect it to rise drastically throughout 2013. When this happens, the stock market will initially rise, and then I expect it to come under extreme pressure.
It is important to point out that when rates rise -- and there is an excellent chance they will rise from this level -- you will see prices drop and valuations on stocks get tested.
As Wayne Gretzky famously said, "skate to where the puck is going to be, not to where it is."