Wednesday, November 16, 2016

A Big Picture Explanation of What Affects the Direction of a Country's Stock Market

Investors can choose to earn returns through yields (interest payment) from bonds or dividends from stocks. Bonds (which are like loans) pay out a coupon (interest) on their principle. Stocks (not all) pay out dividends. But dividend payouts are not a certainty, and depends on the company's performance. The bond yield of a country is usually measured by the yield on its 10-tear bond. The dividend yield of a country is the dividend yield of its dominant stock market Index e.g. the SP500 or Singapore's STI.
One measure of whether a country's stock market is still attractive is the difference (spread) between the dividend yield of its stock market and the yield on its 10 year bonds. Sovereign bonds are risk-free investments (theoretically) and so a choice between bonds and stocks is a choice between no risk and some risk but potentially higher gain. The bigger (on the positive side) the spread between the two asset classes, the more attractive the stock market is. If bond yields go up, investors would prefer to put their money in bonds instead of the stock market.
The yield on US 10-year Treasuries used to hover around 1.75 % for weeks just before the Presidential elections. In May, it has hit a low of 1.32 %. When Trump won the election it shot up, and is now 2.23 %. So is the US stock market still attractive? If you look at the chart, it is barely so, since the spread between the average US dividend yield and the 10 year Treasuries yield is only 0.013%.
The greatest spread of 3.041 between stocks and bonds is in the UK. On the other hand, you can see that the negative spreads are all in currently countries which have economic or political or currency problems (e.g. Russia, Brazil, Turkey, Argentina). If you look at Japan, the reason why its stock market is still reasonably attractive is because: although the dividend yield is only 2.09, the 10 year bond yield is negative (-0.01) and therefore the spread is still quite significant. The dividend yield on Russian stocks is very high viz. 4.96. But the bond yield is also very high viz 8,78. And therefore the spread is negative.
Of course dividend yields and bond yields change every day, since they are a function of stock prices and bond prices. But if you had a time series (chart) of the spread which shows how it is changing each day, it would be very useful. [This can be done if you have a Bloomberg terminal].
With the change in the US Presidency, the markets have already priced in rising interest rates and inflation as they think that Trump will attempt to fix the economy by incurring higher national debt. So you can see that US 10 year bond yields are rising, the rest of the world will (and must) follow, and all things being equal stock markets in general are in for a rough time. [US$ is rising because higher US interest rates make the Dollar more attractive.]
* Stock and Bonds data from and as at 16 Nov 2016.

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