US Stock Market: Wall of Worry Forming Over Rising Yields, Stretched Valuations, Complacency

The major U.S. stock indices are trading mixed shortly before the cash market opening on Wednesday. The futures contracts have been seesawing throughout the overnight session after hitting record highs on Tuesday.

All three majors – S&P 500 Index, Dow and NASDAQ-Composite – are being capped by a rise in Treasury yields, but some investors are also expressing concerns about valuations. Complacency could also be an issue with the VIX falling below 20%.

At 10:50 GMT, March E-mini S&P 500 Index futures are trading 3925.25, down 2.50 or -0.06%. March E-mini Dow Jones Industrial Average futures are at 31453, down 5 or -0.02% and March E-mini NASDAQ-100 Index futures are trading 13741.75, down 26.00 or -0.19%.

Rise in Treasury Yields New Concern

The 10-year Treasury yield topped 1.30% on Tuesday, a level last seen in February 2020. The 30-year rate also hit its highest level in a year. Some on Wall Street believe higher rates could prompt investors to rotate out of equities and into bonds, while also putting pressure on areas of the market, including tech, which have benefitted from the low-rate environment.

Valuations May Be Stretched

“If you look at any historical norms, valuations are stretched. But we’ve never seen the long bond at 1.3% and so we’re in unchartered waters here so higher P/Es are justified based on lower interest rates,” said Scott Black, founder and president at Delphi Management. “The other thing is the Fed’s going to be highly accommodative…they’re going to keep interest rates low, and so you have the wind to your back.”

But, LPL Financial’s Jeff Buchbinder believes these fears might be overblown.

“Our preference for stocks over bonds – supported by low interest rates – is one of our highest conviction recommendations for 2021,” the equity strategist said. “Several segments of the equity market – particularly the energy sector and banks – offer higher yields than traditional high-quality bonds and offer attractive capital appreciation potential as interest rates rise,” he added.

The conflict between the two schools of thought could be the source of short-term volatility in the stock market.

Complacency Setting In

The CBOE Volatility Index (VIX), known as Wall Street’s “fear gauge” is currently near its lowest level in nearly a year. This indicates complacency or a “what me worry?” tone, occurs when investors become over-optimistic.

Investors are buying more call options, while betting on the rally to continue, and fewer put options, which provide protection against a steep sell-off.

Contrarian investors believe this may be indicating a sharp correction is likely over the near-term.