05.11.2022: Nasdaq stocks have been on a wild run. For the three years ending in 2021, the Nasdaq 100 outperformed the S&P 500 by more than 32 percentage points. While innovation and disruption made for a great narrative, most of the tech-heavy outperformance was attributed to dramatically lower real rates, most notably, the 10-year Treasury yield relative to expected inflation. Between 2019 and 2021, the 10-year Treasury “real” yield plunged from positive one percent to negative one percent.
Blame persistent inflation and a suddenly hawkish Fed, real rates have made a U-turn. 10-year real rates have spiked about 1.3%, to about 0.28% so far this year, turning the Nasdaq, its biggest beneficiary, into its biggest victim. The Nasdaq 100 has fallen more than 23% this year, underperforming the S&P by about 12 percentage points. Based on their historical relationship, it appears that the NDX has a little more wood (no pun intended) to chop to the downside.
Negative real rates were a secular eventuality. The world’s developed economies and markets, like a drug addict, required ever-lower real rates to keep maintain positive activity without recession. Each of the last five recessions, from 1982 to 2020, were sparked by successively lower real overnight rates. Moreover, it also took successively lower real overnight rates to kickstart each subsequent recovery. Even though the Fed has a bit more tightening to go from here to combat the current inflationary environment, we doubt overnight rates will need to push above 3% to dramatically slow demand. The two-year Treasury yield, at 2.6%, underscores that view.
A lower ceiling on rates is good news for the broader equity market, since it’s unlikely interest rates would have the chance to pull the rug out from under valuations before demand slows and brings inflation under control. Cresset’s copper/gold model, what had successfully signaled for higher rates, now suggests the 10-year note has already overshot fair value on a yield basis, implying the 10-year yield should be 2.5%, not 3.0%. This is the first time since 2019 that our copper/gold model is signaling lower yields.
If our 2.5% 10-year yield is correct, then most of the S&P 500 selloff is behind us. At the outset of 2022, the 10-year Treasury note yield was 1.51% and S&P earnings were expected to grow by about 7% for the year. Adjusting to a 2.5% 10-year yield and 9% earnings growth implies a 16% year-to-date market decline to adjust for higher earnings discounted at a smaller price-earnings ratio. To date, the S&P is, in fact, off about 16%, suggesting that blue chips are nearing fair value. Of course, a lot depends on what happens to the 10-year Treasury yield. While big tech stocks have some downside risk left, the overall equity market appears to be in reasonable shape, given what we expect is a gradually slowing environment.