Bond Yield Rally Bodes Well for Stock Market Bulls

The following is a reprint of the market commentary from the March 2018 edition of The Option Advisor, published on February 23. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.

Ask the average trader to find the culprit behind the recent stomach-churning sell-offs in the stock market, and they're quite likely to point to the finger at rising bond yields. A quick Google News search for the seemingly innocuous phrase "bond yields" turns up dozens of headlines from the past month connecting these dots:

Bond Yields Starting to Threaten Stocks - Barron's, Jan. 30
US stocks tumble as bond yields hit multiyear highs - Financial Times, Feb. 2
Dow Gets Walloped, Falls 665 Points as Bond Yields Spike - TheStreet.com, Feb. 2
Stock-market melt-up takes a timeout as bond yields rise - MarketWatch, Feb. 3
Rising bond yields could win next round in battle with stock market - CNBC, Feb. 7
Bond Yields Are Getting Closer to the Next Big Pain Threshold - Bloomberg, Feb. 14
Stocks sink as bond yields, dollar regain traction - Reuters, Feb. 20

Since you're a seasoned enough investor to be reading this newsletter right now, I probably don't need to "explain like you're 5" why sudden or unexpected bond yield increases have the ability to spark tremors and volatility shocks in the stock market. Higher bond yields not only diminish the attractiveness of investing in equities relative to Treasury notes, but they also drive up borrowing costs -- effectively raising the prospect of constricted lending and spending among corporations.

And what's driving the bump in bond yields? Inflation worries, mostly; CNBC recently reported that the three-month annualized average of 2.88% core inflation is the highest such reading since 2008 (which surely ranks high on the list of calendar years about which investors would prefer not to reminisce). And we may yet be in the very early innings of this trend, given that we're only now seeing the impact of fresh fiscal stimulus (via the late 2017 "tax cuts" bill) hitting an economy that's (arguably) already hovering around "full employment."

So to what extent should traders be panicking over runaway bond yields? Well, perhaps a bit less than newly minted Fed Chair Jerome Powell, to be certain -- but investors can actually take heart in the results of a recent study by Schaeffer's Senior Quantitative Analyst Rocky White, which suggests that similarly steep, strong ramps in Treasury yields have not been a reliable leading indicator for stock market losses.

As our guiding benchmark, we turn to the Cboe 10-Year Treasury Note Yield Index (TNX), which serves as a proxy (times 10) of the underlying bond yield. Per the accompanying chart, yields have been rising considerably higher since mid-December, with the pace of the rally increasing after a pop above 2.5% (as represented by TNX 25) in early January.

In fact, as of Friday, Feb. 16, TNX had notched a year-to-date gain of nearly 20%, and closed a 42nd consecutive session atop its rising 20-day moving average -- the equivalent of two months' worth of trading days. Going back to 1990, there have been just eight times where TNX has managed such a lengthy winning streak above its 20-day moving average... and the S&P 500 Index (SPX) returns following prior signals suggest that previous such streaks have been resoundingly bullish indicators for equities.

Looking at the average returns after TNX spends two months or more above its 20-day, the S&P outperforms its "anytime" results over the next week, month, three months, six months, and year. The percentage of positive returns is fairly staggering, too, with not a single negative return over the one-week, six-month, and one-year time frames after a signal. (For what it's worth, the most recent signal occurred on Dec. 2, 2016 -- and we'd say 2017 was a fairly good time to have been long stocks.)

Granted, the usual caveats apply to this data set -- eight occurrences is not a convincingly robust sample size, and this is simply one indicator out of many that can offer clues as to where the stock market is headed next. But we do feel comfortable saying, in light of this study, that the rise in bond yields is most certainly not a "sell" signal for U.S. stocks -- and instead, it could once again prove to be just the opposite.