Does bond scaremongering make sense, or is it just a false alarm? Let's finally answer it:

Interest rates like in 1987

On October 19, 1987, the Dow Jones fell 22.6% in a single day. It remains the worst day in Wall Street history. The yield on the ten-year US Treasury is over 5.2%. In February it was around 4.1%. This is exactly what 1987 looked like, when the yield shot up from 7% to over 10%. However, much more important than the level of the yield is the speed of its rise.

Why rates are rising

- Inflation has been above the Fed's target (2%) for over 5 years

- Kevin Warsh, from whom Donald Trump expected rate cuts, did the exact opposite on September 16 and the Fed raised rates to 3.75–4%, for the first time since 2023

- A flood of new debt, because the US government and the biggest tech companies building data centers are borrowing. The same trend is visible in the UK and Australia, where the ten-year yield is also above 5%

When the government pays you over 5% a year risk-free, stocks must offer more, otherwise money will flow out of them. And bonds today pay the most since 2007.

A completely different market

In 1987, the S&P 500 index rose 39% by the end of August, without corporate earnings keeping an adequate pace. Stocks earned less than $5 for every $100 of value, while a bond paid over 10%. Thus they lagged bonds by a full 5 percentage points.

This year, the index is up less than 13%. But corporate earnings are expected by analysts to grow 32% for the full year. Forward P/E therefore fell from 20.4 to 19 since the end of June, below the ten-year average. Looking forward, stocks are roughly on par with bonds, not 5 points behind as before Black Monday.

A possible problem in earnings

The seven largest tech companies reported profit growth of 118% in the second quarter, the most since 2020. But a large part does not come from the business itself. $GOOG booked $98 billion in profit from revaluation of investment stakes and $AMZN $53 billion, mainly thanks to its stake in Anthropic. Without these two companies, the earnings growth of the seven falls from 118% to 43%.

Valuations of private AI companies rest on cheap money and willingness to pay for the future. And rising rates are taking that away.

Which stocks are at risk?

The most sensitive are companies with high debt and weak earnings. Dividend stocks from energy and real estate also tend to be under pressure, because a similar payout is now offered by a risk-free bond. Furthermore, growth companies whose earnings are expected only many years from now, because a dollar earned 10 years from now is worth less today at higher rates.

What history says

I looked at the 5 biggest rate shocks since 1987. Then the yield jumped by more than 3 percentage points and the index fell 33%. In 1994 it was almost 3 points and a drop of 9%, in 2013 over 1 point and only 6%, in 2022 2.7 points and 25%, and in 2023, when the yield last reached 5%, the index lost 10%.

The median of these declines is 10%. From today's 7,722 points that would mean a fall below 7,000, roughly where the index started this year.

After each of those shocks, the S&P 500 reached new highs within about 2 years at the latest, so for a patient investor, declines have so far always meant a cheaper purchase.

If you want to learn more about the topic, check out this video where I broke it down in the finest detail: