Interest Rates Could Trigger the Bear Market

One of the best investors in the world made a very bold and precise forecast about the stock market trading in 2018. That investor is Jeff Gundlach, the man who replaced Bill Gross as the Bond King in the mind of many analysts.

According to Forbes, “Gundlach is known for his arrogance and bold calls–having correctly predicted the housing crash in 2007 and the decline of interest rates in 2013 and 2014.” The magazine estimates Gundlach’s personal net worth at more than $1.8 billion.

Gundlach is the founder of DoubleLine Capital LP, an investment firm with more than $100 billion in assets under management. He was formerly the head of the $9.3 billion TCW Total Return Bond Fund. At TCW, he finished in the top 2% of all funds invested in intermediate-term bonds for the 10 years that ended prior to his departure.

Gundlach’s 2018 Outlook

Overall, Gundlach is bearish on the stock market this year. The stock market is likely to end its record streak of positive returns this year, according to his full year forecast although he doesn’t expect the market to move straight down.

He recently told investors, “My prediction for 2018 is that the S&P 500 will have a negative rate of return. It may go up 15% in the first part of the year, but I believe when it falls, it will wipe out the entire gain of the first part of the year and end with a negative sign in front of it.”

The decline could be triggered by a specific event. It’s even easy to track this forecast. Higher interest rates are one catalyst that could drive the stock market lower, he said. If the 10-year yield rises above 2.63%, it could start to hurt equities, Gundlach said.

The current 10-year rate briefly topped that level last week.

maturity rate

Source: Federal Reserve

If the Federal Reserve proceeds with its plans to increase interest rates this year, the yield on the 10-year is likely to move significantly above the 2.63% level cited by Gundlach.

Why Interest Rates Matter to Stocks

There is a well established link between the stock market and interest rates. One of the first analysts to describe this relationship was Ben Graham, Warren Buffett’s business school professor and mentor.

Graham explained that the relationship was important because of an indicator known as the earnings yield. The earnings yield is the inverse of the price to earnings (P/E) ratio. That means the earnings yield is the E/P ratio.

This relationship can be seen in the next chart. This chart simply shows a series of P/E ratios as the blue line and the earnings yield as the orange line.

P/E and Earnings Yield

The chart makes the relationship clear. When earnings yields are low, the P/E ratios will be high.

The earnings yield defines earnings as the return on an investment an owner of the company would receive. Since shareholders are the owners of the company, it can make sense to look at the E/P ratio when making investment decisions to provide the return from the perspective of an owner.

When making a decision about where to invest money , a business owner will frequently consider several alternative investments. In many ways, stocks and bonds are alternative investments. Rational investors should be expected to favor the asset with the best return.

Now, assuming risks are equal, it makes sense to assume that a majority of investors will select stocks when the E/P ratio is higher than the interest rate available on bonds. When interest rates on bonds are higher than the E/P ratio, money should flow to bonds instead of stocks.

Stocks and 10-Year Treasury Yields

Graham went a step further and used yields to describe when stocks were a better investment than bonds. He believed the “right” P/E ratio for stocks could be thought of in comparison to the 10-year Treasury.

Remember the P/E ratio is the inverse of the E/P yield and that means the “right” P/E ratio should be the inverse of the 10-year yield under Graham’s formulation. This means if 10-year notes yield 10%, to use a simple number, we would expect stocks to trade with an average P/E ratio of 10 (1 divided by 1%).

If interest rates fall to 5%, the P/E ratio should increase to 20. At a 1% interest rate, stocks could be fairly valued with a P/E ratio of 100.

Gundlach appears to be following a less rigid interpretation. He seems to be saying when investors feel certain that interest rates on the 10-year are rising, they will start switching to bonds from stocks. In his analysis, the key rate will be 2.63%.

10 year yields

It won’t be an immediate switch. Gundlach noted that the market is in an “accelerating” phase that makes it unlikely that it reverses that trend this year.

“It takes time for momentum to wane, it takes time for sentiment to disperse a little bit and generally it takes earnings to start going down before you start to see something happening,” he said.

Still, this year is likely to be more interesting and “less profitable” than 2017, Gundlach said.

More Reasons to Favor Bonds

Gundlach made a precise prediction but the shift out of stocks can be supported with less specific data. Investors are simply motivated by gains. They invest money in the hope of receiving more money later. But, they understand there is a risk of loss.

The risk of loss motivates investors to consider safety. This year, the bull market that began in March 2009 will celebrate its ninth anniversary. The age of the bull market raises fears that the trend will reverse. That is simply based on the belief that no trend lasts forever.

Valuations are now stretched and that also raises fears among investors. But, for now, investors may feel there is no alternative to stocks. Higher interest rates will alleviate that concern and provide an alternative to investors nervous about stocks.

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