Stock Market Enters Dangerous ‘TARA’ Regime

As the bleed-out in stocks continues, the bearish mood sweeps Wall Street.

Last week, Morgan StanleyMS
reiterated their earnings recession call. They predict stocks are in for another haircut because the market overshot with earnings projections. And then there’s an issue of rising real yields.

Real yields are also the reason Goldman Sachs trimmed their year-end forecast for the S&P 500 from 4,300 to 3,600 and called equities “underweight.” Meanwhile, Blackrock went as far as to advise its clients to “shun most stocks.”

Why are real yields so important that they scared most of Wall Street into the fetal position?

From “TINA” to “TARA”

There are two main asset classes that fight for a place in each portfolio: stocks and bonds.

As a rule, bonds are a safer investment that gives investors a steady income with a relatively low risk. The catch is that investment-grade bonds pay out little and don’t always protect from inflation.

Stocks earn more, but at a risk. Their income is not guaranteed, and stock prices can be very unstable. That’s why investors ask for a higher return from stocks as compensation for taking that risk.

This is the reason the price investors are willing to pay for stocks depends not only on where they are in terms of their historical valuations, but also on how they stack up to valuations of other asset classes, especially bonds.

But look what happened during Covid.

After Covid swept the world, the Fed slashed interest rates to zero, which in turn pushed down bond yields. For example, the real yield on the world’s most popular bond-10-year Treasuries—fell into negative territory.

And while inflation has been picking up since the beginning of 2021, the Fed sat on its hands until very recently.

All this kept real yields in the red, which meant bond investors were essentially losing money. So they were left with no other option than to invest in overvalued equities to protect themselves from rising inflation.

Goldman Sachs dubbed this period TINA, or “there is no alternative.”

But now the tide has turned.

Earlier this year, the Fed launched the fastest tightening program since the 1980s. In his quest to tame inflation, Powell pulled five hikes bringing rates from near zero up to 3.25% in just a little over half a year.

And for the first time since the beginning of 2020, real yields made into positive territory. In fact, they are now at the highest level since 2008. And this is not the end.

The Fed’s median forecast shows that it expects to hike all the way to 4.6% in 2023. That’s still a long way to go, and a lot of room for real yields to rise, which doesn’t bode well for valuations because real yields largely correlate to the S&P 500’s forward P/E.

Goldman Sachs calls this turn of events TARA. “Investors are now facing TARA (There Are Reasonable Alternatives) with bonds appearing more attractive,” its analyst wrote in a recent note.

Looking ahead

As investment-grade bonds begin generating real income after years of negative returns, the market comes back to normalcy where investors have options to swap out overvalued equities with safer fixed income.

Will stocks manage to grow their earnings as much as to make up for the loss of their allure against growing bond income? Or contrarily, will we see a Morgan Stanley-predicted earnings recession, which will make stocks even less attractive?

Keep an eye on things like real yields and earnings yield to keep your finger on the market pulse.

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