The Most Important Number in the Market Isn’t the S&P 500

Most investors look at the S&P 500 as their gauge of whether the market is doing well. Right now, I would argue that another number matters more: the yield on the 10-year U.S. Treasury bond. This week, the 10-year yield climbed above 5.2%, reaching levels we have not seen since 2007. On Monday alone, it traded as high as 5.27%. That move has helped push the S&P 500 down about 1% to start the week, with the Nasdaq falling even more. This is a fairly normal market reaction. When the risk-free rate changes, the math behind virtually every other investment changes with it. That is what makes the 10-year yield one of the most important charts investors should be watching right now.

What about TINA?

After the 2008 financial crisis, the Federal Reserve and the natural forces of the bond market caused interest rates to fall to historic lows, where they remained for more than a decade. TINA—the acronym for “there is no alternative”—became famous. Cash paid essentially no return, and Treasuries did not pay much more. If you wanted a reasonable return on your invested capital, you almost had to put money into the stock market. That environment played an enormous role in supporting unusually high equity valuations because investors were willing to pay high multiples for stocks when the alternatives were so unattractive. What has happened in the U.S. Treasury market over the last couple of years, and particularly in the last 30 days, has changed that market reality. Today, an investor can buy a U.S. Treasury yielding above 5% without taking corporate earnings risk. There is now an alternative to the S&P 500, particularly for baby boomers who are reaching an age when equity risk and extreme equity valuations are becoming increasingly unattractive.

Why higher yields pressure stock valuations

A stock is ultimately a reflection of the present value of the future cash flows a business will generate. The further out those cash flows are, the more important the risk-free discount rate becomes. That is why high-growth technology companies can be particularly sensitive to changes in interest rates. When investors buy a stock today based on cash flows expected 10 years from now—as they might with SpaceX, Palantir, or Anthropic—the present value of those future cash flows declines as interest rates rise. Higher interest rates do not necessarily destroy earnings; they simply reduce the price investors are willing to pay for those earnings today. Earnings have more work to do. Companies can earn more money with the 10-year yield at 5%, but a higher yield can reduce the earnings multiple investors are willing to pay for future cash flows. Consider a market trading at around 20 times earnings, which produces an earnings yield of approximately 5%. At first glance, an investor might ask, “Why would I accept all the uncertainty associated with stocks when I can earn approximately the same yield from the U.S. government?” That sounds like a powerful bearish argument. However, there is an important flaw in that comparison.

Jeremy Schwartz, global chief investment officer at WisdomTree, made this point nicely over the weekend. He wrote, “Stocks are real assets; earnings and dividends have been shown to outpace and grow with inflation over time. TIPS are the right comparison.” A traditional Treasury bond gives you that 5% yield, but if inflation rises, the coupon payment does not automatically rise with it. Your purchasing power can therefore deteriorate even while you continue receiving the same interest payment. Stocks are different. A business can raise its prices, and companies can grow even if the economy does not. Earnings can grow, and dividends can increase over time. Equities therefore behave much more like real assets than financial assets. That means the better comparison is not necessarily the S&P 500 earnings yield versus the nominal 10-year Treasury yield. It may be the earnings yield versus the real yield on Treasury Inflation-Protected Securities, or TIPS. Viewed that way, the equity risk premium has certainly come down, but it has not disappeared. Schwartz estimates that there is still roughly a two-percentage-point cushion between equity earnings yields and comparable real Treasury yields. During the internet bubble in 2000, by comparison, TIPS yields were around 4% while the earnings yield on the S&P 500 was around 3%. That was a scenario in which investors could earn a higher real yield from government bonds without taking the risk of owning stocks. This is not the environment we have today—at least not yet. The cushion is much smaller than it has been during the last 20 years, but there is still a cushion. The ultimate question for me is whether earnings can continue growing fast enough to justify the additional risk of owning stocks. If the answer is yes, the bull market can continue even with the 10-year yield above 5%.

The Trade

For options traders, this environment points me toward a predefined-risk trade. Rapidly moving bond yields create a scenario in which equity markets can react violently to economic data, inflation reports, and even comments from Federal Reserve members. Rather than structure a trade that depends on the market moving straight up or straight down, I would rather know my risk before I enter. I also need to monitor implied-volatility levels. When option premiums become expensive, that may create an opportunity for a volatility trade in which I sell volatility. One example is an iron condor on SPY or QQQ using shorter-duration options with one to two weeks until expiration. I would typically structure the trade two or three strikes out of the money, focusing on probability, standard deviations, and the overall risk-reward profile.

The key chart to make sure it all works, isn’t necessarily the SPY or the QQQ. It’s more likely the yield of the 10 year US Treasury and the 10 year TIPS. If and when those charts break, the vol we’ve been seeing held in check up to this point may explode.