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Will the S&P 500 Extend Its Record Rally Against Rising Yields and USD?

S&P 500 FUNDAMENTALFORECAST: BULLISH

  • US stocks returned to ‘rally mode’ amid strong earnings, vaccine rollout and fiscal stimulus hopes
  • A strengthening US Dollar and rising Treasury yields may hinder the rally however
  • The S&P 500 index is trading at a 31.6 price-to-earnings (P/E) ratio, far above its 5-year average

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Global stocks are back to ‘risk on’ mode after a brief pullback seen in the end of January. Investor confidence appeared to be revitalized by strong Q4 corporate earningsand guidance, falling Covid-19 cases and hopes that Democrats can push through a large fiscal stimulus package soon. Renewed reflation hopes – expectations that demand and output will pick up with fiscal spending – have also led the US Dollar to strengthen alongside rising longer-dated Treasury yields, which may hinder stock markets’ rally.

The DXY US Dollar index and the S&P 500 index exhibit a historic negative relationship, with the past 12-month correlation coefficient standing at -0.892. This suggests that further strengthening in the Greenback may exert pressure on the S&P 500 index, as more than 40% of the index constituents’ revenue comes from overseas. A stronger US Dollar simply translates into lower overseas sales due to foreign exchange differences. For emerging markets, a stronger USD may also discourage capital inflow and weigh on equity performance.

S&P 500 vs. Dollar Index Chart

Source: Bloomberg, DailyFX

Longer-dated US Treasury yields are climbing, leading the yield curve to steepen further. Rising Treasury yields make stocks less appealing as compared to government bonds, as the later seem to be offering better reward-to-risk ratio now.

1-Week Changes in US Treasury Yields

Source: Bloomberg, DailyFX

Nonetheless, an improved fundamental picture and robust Q4 corporate earnings may continue to buoy equity prices. The job market showed signs of improving, with the vaccine rollout helping to bring down daily Covid-19 infections rapidly in the past few weeks. The ADP private payrolls number and weekly unemployment claims figure both beat market expectations last week. The Fed’s commitment to a dovish stance at the January FOMC meeting alongside a similar tone from the RBA and BoE points to an extension of the current accommodative monetary environment. Against this backdrop, investors may be incentivized to park their money in riskier assets looking for yield and growth.

Q4 US corporate earnings fared well so far, with more than half of S&P 500 companies having already released their results. Among those, 83% have beaten market expectations with an average positive earnings surprise of 20.3%. Big tech companies and banks contributed most to earnings growth, while energy sector lagged. Encouragingly, more companies are issuing positive EPS guidance for Q1 2021, showing that business decision-makers are more optimistic about the recovery outlook, and are probably more willing to expand capex in the months to come.

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Valuation-wise, the S&P 500 index is trading at a 31.6 price-to-earnings (P/E) ratio, which is the highest level seen in two decades and more than 50% above its five-year average of 21.0. Rich valuation may render the index vulnerable to profit-taking should rising yields and a stronger US Dollar hinder stock markets from reaching higher highs.

S&P 500 Index vs. P/E Ratio – 5 Years

S&P 500 vs. P/E Ratio Chart

Source: Bloomberg, DailyFX

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— Written by Margaret Yang, Strategist for DailyFX.com

To contact Margaret, use the Comments section below or @margaretyjy on Twitter

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