The bond market continues to signal a warning that investors should take seriously.
The 10-year Treasury yield hit 5.34% last week, its highest reading since 2007. It finished September at a modestly lower 5.29%, but it's still up roughly 50 basis points since the end of August.
That's potentially bad news for stocks. Higher yields increase borrowing costs for both consumers and businesses, make future corporate profits less valuable today, and give investors an increasingly attractive alternative to equities.
But there's one conclusion that investors shouldn't necessarily draw from this: It's time to sell your S&P 500 (^GSPC +0.66%) index funds.
History suggests that could be exactly the wrong move.
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Here's what happened after similar yield spikes
The recent increase in rates has been extreme enough to make historical comparisons worth reviewing. UBS recently examined periods when the 10-year Treasury yield climbed by at least 1.5 standard deviations above its 1-year average. It found that it's only happened eight times since 1985.
In those situations, the S&P 500 on average was relatively flat in the three months following those yield spikes. But then the index gained roughly 5%-10% over the subsequent six to 12 months. That's interesting because investors are often told that rising rates are bad for stocks. History, however, shows that higher yields may not be the headwind to equity prices that many people think.
Long-term yields can rise because investors expect stronger economic growth and persistent inflation, both of which can accompany rising corporate revenues and earnings. Today's environment also features both, meaning what we're seeing right now may be historically normal rather than an anomaly. A rising 10-year yield can create a problem for valuations without necessarily becoming an earnings headwind.
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Of course, there's no guarantee that stock prices will keep climbing here. But high yields could create short-term volatility.
The Shiller CAPE ratio, which measures stock prices against inflation-adjusted earnings over the past 10 years, recently reached 41.4. That's its second-highest level in history, only after the peak of the dot-com bubble. Today's high valuations arguably make rising rates more dangerous than usual.
That's also why short-term volatility shouldn't be surprising. But selling the Vanguard S&P 500 ETF because the 10-year Treasury crossed 5% effectively requires making two correct decisions: when to get out and when to get back in.
The bond market's warning is worth taking seriously. A 5%+ 10-year yield could mean more volatility and lower valuations. But history offers a lesson. A reason for stocks to struggle in the short term isn't necessarily a reason to stop owning them altogether.
