After enjoying the best kickoff in more than three decades, the S&P 500 posted its biggest decline since 17 August 2017. All ten sectors traded in red territory suggesting that we didn’t see any rotation, but the selloff was broad-based led by Energy, Utilities, and Telecom sectors.

The factors which supported the rally over the past couple of months are still in play. Global synchronized growth, enthusiasm over the Trump administration’s tax cuts, and strong earnings growth. According to Factset, more than 76% of S&P 500 companies have reported positive EPS surprises and 81% have reported positive sales surprises. These figures represent a record high in terms of U.S. companies beating sales estimates.

Given this optimistic view, many investors may consider buying the dips. This strategy has been profitable during the stock market uptrend, so why not buy the dips now?

Few will disagree that valuations are overstretched, however, due to low global interest rates, equities have remained attractive during the past couple of years.

Now with U.S. 10-year Treasury bond yields trading above 2.7%, and breaking above a three-decade downtrend, the uptrend in equity markets will be under a new test. Not only U.S. interest rates are on the rise, but German 5-year bund yields moved into positive territory for the first time since December 2015 and Japan’s 10-year yields are trading at a 7-month high.

The rise in global bond yields isn’t necessarily a bad thing; it reflects the strength of the economic recovery. However, the pace of the rise in yields may create significant headwinds for equities in the days to come, especially if U.S. 10-year yields break above 3%, a very critical physiological level in my opinion. A simple question that may come to investors mind, is “why would I remain in equities when two-year U.S. treasury bills can provide the same divided yield return of the S&P 500 at 2.12%?."

The CBOE’s volatility index VIX edged up 25% on Monday, the highest close since August last year, suggesting that investors are demanding put options to protect their portfolios from potential downside risks.  This combination of higher bond yields and the VIX increase, are catalysts for a further correction in the days to come, so keep a close eye on these two indicators.

 

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