Most investors are simply not prepared for rising bond yields

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Traders on the floor of the New York Stock Exchange

Source: NYSE

Equity markets fluctuated last week as US Treasury yields rose, and a fund manager has warned that equity investors are ill-prepared for the “pain” ahead.

Cole Smead, president of Smead Capital Management, told CNBC Tuesday that investors would have to weigh whether a company will be positively affected by the economic recovery or negatively by how those recoveries will affect the “price of money”.

“That dichotomy between winning the economy and losing the stock market. I don’t think investors even cared about it,” said Smead.

His comments stem from a sharp rise in the yield on the benchmark 10-year Treasury note over the past week. The move, driven by the introduction of vaccines and hopes of pent-up demand, heightened growth and inflation expectations and threw risk-weighted assets on their knees as investors contemplated the possibility of central banks tightening monetary policy.

Stocks can often fall when interest rates rise as large companies have to pay more to service their debt, causing investors to reevaluate the trading environment.

The spike in yields declined a little late on Monday and the 10-year yield was around 1.4256% in Europe on Tuesday afternoon, close to the level seen a year ago when the Covid-19 pandemic spread across the world spread.

However, Smead pointed out that the 10-year return was above 3% at the end of 2018, suggesting that a return to the underlying economy could have a stronger negative impact on the stock market.

“I’m 37 years old and most people my age have never seen a nasty bear market in their lives. They could barely breathe in the spring, but they’ve never seen really terrible stock markets, and they’ve never seen bonds Have lost money. ” he added.

“I think most investors just aren’t prepared because dogs chase cars and people chase stocks. It’s the nature of the animal.”

The recent surge in yields has resulted in further rotation into so-called cyclical stocks, whose performance tends to be in line with the strength of the broader economy such as energy and finance. Smead suggested that “while market risk looks terrible, investment risk is wonderful,” noted that his firm had bought stocks of mall operators like Simon at cheap prices.

“It’s just a whole different conversation than saying, ‘How much will the S&P 500 earn next year?’ And only God knows what someone is going to pay for that revenue on a valuation basis, “he said.

The majority of U.S. blue-chip companies that have reported full-year 2020 profits in the past few weeks have exceeded analysts’ expectations. However, Smead suggested that market valuations may have moved away from these fundamentals and may have been vulnerable if the economic recovery continues to fuel the recent surge in bond yields.

“With the S&P 500 moving away from tangible or intangible assets, there is no link today between those assets and the price of the stocks in relation to the market,” he said.

“I think this is where the stock damage is going to be – if people wake up with it. We could see some hell and pain in the next two to three years,” added Smead.