Signs of Potential Opportunity for Stocks as Bond Yields Decline

Bond yields have shown signs of reaching their peak, and if they continue to drop, it could present an attractive opportunity for various stocks.

The recent surge in bond yields, driven by expectations that the Federal Reserve will maintain high interest rates to combat inflation, has been remarkable. The yield on 10-year Treasury debt briefly surpassed 5% this week, reaching its highest level in decades, after starting the summer at just under 3.7%.

However, there are indications that this upward trend may be coming to an end and that yields could soon decrease. For instance, the 10-year yield has already dropped to around 4.86% from its peak of 5.02% on Monday morning. This suggests that buyers are entering the market swiftly, pushing up the price of the debt and consequently reducing its yield.

Investors have significant incentives to remain in the market, potentially driving yields even lower. Data from the St. Louis Fed reveals that the yield is nearly 2.5 percentage points higher than the anticipated average annual inflation rate over the next decade. This significant differential, one of the largest since the 2008-09 financial crisis, may attract more bond buyers.

If this scenario unfolds, it would signal a shift in favor of defensive stocks, which have underperformed compared to the S&P 500 this year. Companies operating in these sectors provide goods and services that individuals continue to purchase regardless of the economic situation, allowing their profits to remain stable when other areas experience declining earnings. Consequently, they serve as a safe haven for investors.

Additionally, defensive stocks often offer high and dependable dividends. These dividends become even more appealing as bond yields decline, a trend commonly associated with a weakening economy or decreasing inflation.

A prime example of this dynamic can be seen in the utilities sector. The Utilities Select Sector SPDR fund (ticker: XLU), which consists of regulated utilities like Duke Energy (DUK) and Dominion Energy (D), has seen a decline of almost 17% this year, while the S&P 500 has enjoyed double-digit gains. This performance puts the sector on track for its worst annual underperformance on record, according to Dow Jones Market Data.

Investment Opportunities in Different Sectors

The recent weakness in the market can largely be attributed to the rise in bond yields. However, there are still opportunities for investors to consider. Certain sectors, such as utilities, consumer staples, healthcare, and technology, have shown interesting trends in relation to the 10-year yield.

Utilities: A Potential Upside

Utilities in the S&P 500 have a negative correlation to the 10-year yield. This means that when bond yields decrease, utility stocks tend to rise. If yields continue to drop, investing in utilities could prove profitable.

Consumer Staples and Healthcare: A Similar Story

Both consumer staples and healthcare sectors have experienced a decline this year. However, they also tend to gain when the 10-year yield falls. The Vanguard Consumer Staples exchange-traded fund (VDC), consisting of companies like Procter & Gamble and Coca-Cola, has seen a 6% decrease this year. Similarly, the Health Care Select Sector SPDR fund (XLV), which includes UnitedHealth Group and Johnson & Johnson, has also declined by around the same amount.

Technology: A Unique Opportunity

Unlike other sectors, technology is negatively correlated with the 10-year yield. This means that declines in yields often lead to a jump in tech stocks. Rapidly growing tech companies are particularly attractive to investors due to their future earnings potential. Additionally, lower yields on long-dated debt increase the current value of these earnings.

The Technology Select Sector SPDR fund (XLK), consisting of companies like Microsoft and Alphabet, has outperformed the S&P 500 this year. The excitement surrounding advancements in artificial intelligence has boosted expectations for these companies' profits. However, the recent rally has slowed down as the fund dropped from its record high over the summer.

Considering the potential opportunities in these sectors, it may be a good time to evaluate and invest accordingly.