Multiple market forces are aligning in favor of continued stock gains — and they all trace back to record-low bond yields, according to a top Wall Street strategist

• Today's low-yield environment established three conditions likely to lift the stock market for months, Jim Paulsen, chief investment strategist at The Leuthold Group, said in a client note.
• The S&P 500 performs the best when yields sit in their lowest quartile, Paulsen highlighted.
• Low-yield environments are the only ones in which the S&P 500 still notches average monthly returns even when earnings decline.
• The prospect of yields staying low for a prolonged period "provides an excellent foundation for the S&P 500," Paulsen said.
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Today's historically low bond yields may rankle some, but they set up an opportune environment for those holding stocks, according to Jim Paulsen, chief investment strategist at The Leuthold Group.

Even as stocks sit near record highs, many are sticking to bonds as a safe-haven play. The trend has kept yields at record-lows through the pandemic, lessening their relative appeal in the eyes of nervous investors. However, Paulsen advised clients in a Friday note that the low-yield environment should pull even the most risk-averse toward equities.

Here are the three ways Paulsen expects record-low yields to boost stocks higher.

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Greater gains, fewer losses

For one, the S&P 500 performs the best when yields are in their lowest quartile. Annualized total returns reach 19.8% for the index when yields are so low, compared to just 9.5% in the second-lowest quartile and 5.4% in the second-highest quartile. The benchmark index also posts monthly losses less frequently when yields are at their lowest, Paulsen highlighted.

"In spite of widespread angst during much of this low-yield era, it has produced superior stock market returns with the lowest frequency of market declines," he said.

Happier earnings

Low-yield environments also set the market up to perform better through earnings season, the strategist said. The S&P 500's monthly return totals 24.4% on an average annualized basis when earnings-per-share rise and yields sit in their lowest quartile. That's the second-highest average gain, only losing out to the scenario when yields are in their highest quartile.

Perhaps more surprising is how the market outperforms when earnings decline and yields are at their lowest. While all other yield quartiles see S&P 500 average annualized monthly returns turn negative, the index gains 10.7% on months when profit fall and yields are in their lowest quartile.

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"Unlike any other time, if yields are very low, the stock market has historically done well whether economic and earnings activity improves or worsens. An extremely low-yield environment has proved to be rarefied air for the stock market," Paulsen said.

Additionally, S&P 500 earnings decline far less frequently when yields are in their lowest quartile. The index's trailing 12-month EPS falls just 32% of the months when yields are at their lowest, compared to nearly 40% when yields are in their middle two quartiles and nearly half of the time when yields are in their highest quartile, according to Paulsen.

Best for tech

Finally, low-yield environments are a boon for the market's biggest driver: tech giants. Similar to the trend seen for the entire S&P 500, the index's tech sector performs best on average when bond yields are in their lowest quartile. The sector's monthly gains are the smallest when yields are in their middle two quartiles.

Yet the most notable trend for tech stocks in low-yield environments is their relative durability even when earnings decline. While earnings increases boost the sector's average monthly return to 15.3% in the lowest-yield environment, months of earnings declines still give way to an average return of 12.2%.

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Since tech stocks have driven major indexes' rallies — and brief slumps — over the past few months, their outperformance in low-yield environments stands to lift the broader market so long as yields stay low.

"The 10-year bond yield has never been lower and, based on post-war data, it would need to rise above 3.3% before exiting the first quartile," Paulsen wrote.

He continued: "The combination of extraordinarily low bond yields and the prospect of an earnings revival in the coming year provides an excellent foundation for the S&P 500, in general, and, in particular, its primary leaders — technology stocks."

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