Early February saw another surge in the stock market. The losses experienced in the final trading days of January were recovered quickly and by February 12th, the indexes were reaching new all time highs. However, volatility is still with us. In the final trading days of the month, the market pulled back quickly and the S&P 500 closed -3% below its February high while the Nasdaq was down -6.45% off its February high.
The big story in February was interest rates, not the short term rates that the Federal Reserve controls, but longer term rates set by the bond market. At the end of August last year, the 10 Year Treasury was paying only 0.50%. To illustrate how historically low that is, an investor buying a 10 Year Treasury would be paid only one-half of one percent each year for ten years to hold that bond. The yield moved up to 1.00% by January 2021. The yield has continued to increase in the first two months this year. It climbed as high as 1.60% in late February and settled back to 1.40% as the month ended.
As the longer bond yield has moved higher, it has had a big impact on markets. First of all, when interest rates rise, bond prices decline. So the bond investor I described above has watched the value of his bond decline.
However, higher long term bond yields are positive for the financial sector. Financial stocks have made a significant recovery from the lows last year. Bank stocks were among the hardest hit by the pandemic. They benefit from rising long term rates because they pay their depositors the lower short term yield which is close to 0% and they charge their borrowers the long term yield. This spread is referred to as the yield curve – the difference between long term yields and short term yields. When the yield curve is flat, banks suffer. As the yield curve steepens, banks can realize a net gain on transactions. The impact on banks of the higher long term interest rates is reflected in the rising price of bank stock over the past few months.
Through the spring and summer of 2020, the biggest stock market gains were in the technology sector. By the fourth quarter, as bond yields increased, technology shares traded back and forth and made little progress. This year we are observing what appears to be a rotation from growth stocks to value stocks as the yield on U. S, Treasuries climbs. Growth stocks have underperformed as bond yields rise. The high valuations make them vulnerable to higher interest rates. Financials are leading value stocks higher as mentioned above, and energy stocks and industrials are also participating with higher prices. Further evidence of this shift was seen in the pullback in the last days of February. The Dow and the S&P 500 indexes held up better than the growth oriented Nasdaq market in that brief pull-back.
Growth stocks have outperformed value for most of the last decade. A shift of this nature does not mean that it is over for technology, but history shows us that leadership does rotate between growth and value and it is possible that growth may take a breather and outperformance could be with value stocks for a time.
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Written by Connie C. Guelich, CFP, AEP, CLU, ChFC. This represents our views at the time of this writing, and it is subject to change. It is not intended to be personal investment advice. If you would like to discuss your own account, please don’t hesitate to call us.