US stock traders are setting themselves up for failure - and one Wall Street firm has pinpointed the scenario that could trigger a crash
- US stock traders are relying heavily on a fundamental catalyst that's driven positive returns for much of the bull market.
- Their overreliance on it could have huge negative consequences as interest rates continue to rise, says Societe Generale.
- The firm warns that a stock crash could transpire if one specific scenario plays out.
For much of the nine-year bull market, stock investors have used earnings expansion as a backstop for positive sentiment. And it's gone swimmingly, especially recently, as US companies have grown profits for seven straight quarters.
However, in a cruel twist of fate, that success has fueled overoptimism that could derail the market as we know it, according to Societe Generale.
At the center of SocGen's pessimistic outlook are two frequently cited market headwinds: rising Treasury yields and historically stretched valuations. The former in particular has been a hot-button topic in recent weeks, with 10-year yields climbing above the closely watched 3% level for the first time in four years.
SocGen notes profit growth has historically weakened when bond yields have risen above recent averages, and the 10-year's recent breach would certainly seem to qualify. After all, rising yields increase competition for assets, which can result in a bigger discount rate being applied to future earnings.
"Optimistic consensus earnings growth for the next three years could be a source of disappointment going forward," Praveen Singh, a global asset allocation strategist at Societe Generale, wrote in a client note. "Any lowering of near-term earnings growth expectations could be a potential trigger for an equity market correction."
To make matters worse for the US specifically, SocGen finds that it's among the countries most vulnerable to low earnings growth. So just how bad can it get? The firm ran a series of scenarios to find out.
Their most drastic case was one in which equity earnings peak in 2018, then remain flat in 2019 and 2020. If that's the case, US stocks could drop as much as 18%, SocGen says. A less extreme scenario involving a 2019 peak and a flat 2020 will yield a 9% loss, the firm estimates.
With all of this in mind, it must be noted that SocGen's bearish scenario doesn't apply until 2019 at the earliest - which means traders banking on strong earnings growth can operate unscathed, at least for now.
Bank of America Merrill Lynch is less worried about the potential for rising rates to hurt US equities. In a recent note, the firm's equity strategy team argued "stocks have exhibited a weak and inconsistent correlation with interest rates over time."
BAML highlights 2013, when the benchmark S&P 500 surged 32%, even though 10-year Treasury yields spiked a whopping 126 basis points.
In the end, regardless of which school of thought you prefer, there's no denying that spiking bond yields have Wall Street talking. And based on the reaction so far, it's safe to say it'll continue being a lightning rod for market controversy for the foreseeable future.
