Yesterday's record-setting session for the U.S. stock market was just the latest in a long line of advances. Yet with many investors believing that many individual stocks are overvalued, one key to deciding which stocks to buy now may lie in the much more important move in the bond market yesterday.
What the bond market is saying about stocks
For months, the stock market has moved up even as interest rates have remained low. But that trend has changed lately, and bond prices plunged yesterday, with the yield on the 10-year Treasury rising to its highest level in over a year. The move reflects the concern that investors have about the Federal Reserve potentially ending its program of quantitative easing, and since the Fed's bond purchases have helped keep rates low, investors conclude that ending the program would send rates higher. With bond guru Bill Gross and countless other fixed-income experts having predicted higher rates for a long time, the damage in the bond market could be severe.
For stocks, though, the news is more mixed. Many stocks are sensitive to bond rates and will see their prices fall if higher rates take hold. The stocks to buy now are those that will benefit from higher rates. Let's take a look at three promising areas.
For years, insurance companies have struggled under the weight of low interest rates. The problem for insurers comes from the fact that they rely on investing the premium income they receive in income-producing securities, with the expectation of using that income to offset the costs of claim losses. When rates are low, their investments don't produce as much income, reducing profits.
Rising long-term rates, however, would help boost insurers' income. Already, you've seen Prudential (NYSE:PRU) and Hartford Financial (NYSE:HIG) hit multiyear highs as their shares have anticipated the climb in rates. If that trend continues, then the boost to portfolio income could be substantial enough to provide nice earnings growth, leading to further share-price appreciation even without an expansion in their earnings multiples.
For banks, it's extremely important which rates go up. The key for bank income isn't so much the absolute level of rates but rather the spread between short-term rates and long-term rates. After all, the way the banking business model works is to borrow money from depositors, usually paying low rates on demand accounts like checking and savings accounts, and then to lend that money out for longer periods of time to borrowers. When the spreads are high, banks make more money.
Lately, the Fed's quantitative easing program has hurt banks' net interest income, because the Fed has gone beyond its usual targeting of short-term rates to pull long-term bond yields down as well. Wells Fargo (NYSE:WFC) in particular has seen compression in its margins in recent years, but if long-term rates keep moving higher while short-term rates stay under the Fed's control, then it and banking peers will benefit greatly.
Brokers might seem like an unlikely target to benefit from rising rates, but the key to understanding the impact rates have is to remember that brokers get revenue from sources other than commissions. In particular, brokers hold a lot of cash for investors, and while some of that cash gets squirreled away in Treasury bills and bank CDs, most of it ends up in sweep accounts that are either proprietary money market funds or other money-handling arrangements.
Under normal circumstances, brokers make money through management fees on sweep accounts and more profitable investments for brokerage-account cash credit. But with short-term rates so low, Schwab (NYSE:SCHW), E*TRADE Financial (NASDAQ:ETFC), and other companies have had to subsidize their money market funds, accepting lower management fees in order to avoid having investors' returns fall below zero. A renewal of higher short-term rates will return things to normal and provide a nice boost for Schwab and its money-managing peers.
It's important to remember that interest rates have made upward moves like this in the past without following through into a full-blown bond market crash. Moreover, most analysts remain comfortable in the belief that the Federal Reserve won't allow the negative experience of 1994, when the bond market suffered a similar abrupt upward-rate shock, to repeat itself.
Most people agree, though, that sooner or later, bond rates need to rise. Before that happens, it's important to find stocks to buy now that will produce the results you want later on, helping you not only avoid losses but also reap profitable opportunities from the resulting bond-market carnage.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.
Fool contributor Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.