Rates, Earnings, and What has to happen next…

I’ve spent a lot of time recently talking about the 10-year Treasury yield, market breadth, and why I’ve become more selective with risk. At some point, repeating that yields are high stops adding much value. What matters now is what the market does with them.

That is where I think things are getting interesting.

The S&P 500 finished last week higher again, gaining roughly 1.2%, while the Dow and Nasdaq also advanced. More importantly, equal-weight participation finally improved after seven consecutive weeks of weakness. It’s only one week, and the Russell 2000 still declined, so I’m nowhere near calling this a broad-based breakout. But it was the first real sign in a while that participation underneath the index may be trying to improve.

At the same time, the biggest headwind facing stocks finally gave the market a little breathing room. The 10-year Treasury yield pushed to roughly 5.37% during the week before finishing near 5.24%. That is still an incredibly restrictive level, but the direction matters. Stocks have spent months absorbing higher long-term rates. Even a small pause in that pressure could be enough to allow the underlying earnings story to take control again.

That is really the setup I’m watching over the next several weeks.

I don’t think the market necessarily needs the 10-year to collapse back toward 4%. I do think it needs rates to stop accelerating higher. If that happens while forward earnings continue growing, the S&P looks increasingly capable of another leg up.

The catch is that earnings now have to do more of the work.

1. The 10-Year Has Become the Market’s Pressure Valve

For most of the last several years, investors have been conditioned to focus almost exclusively on the Federal Reserve. Every inflation report became a debate about the next Fed meeting. Every employment report was immediately converted into probabilities for another hike, a pause, or an eventual cut.

That still matters, but I think the more important number for equity investors right now sits farther out on the curve.

The 10-year Treasury yield has become one of the clearest pressure points for this market.

The Fed can stop raising short-term rates and financial conditions can still tighten if longer-term yields continue moving higher. That affects mortgage rates, corporate borrowing costs, commercial real estate, consumer credit, business investment and, ultimately, the valuation investors are willing to place on future corporate earnings.

At approximately 5.24%, the 10-year is no longer background noise. Real yields are approaching 3%, meaning investors can earn a historically attractive inflation-adjusted return from government bonds without taking equity risk.

When Treasury yields were 1% or 2%, the argument for owning equities was relatively easy. Investors searching for meaningful returns had very few alternatives. At more than 5%, the calculation changes. Cash and fixed income are no longer simply places to hide while waiting for stocks. They can generate meaningful returns on their own.

That does not mean stocks automatically need to decline. It means the bar gets higher. The market needs corporate earnings growth to compensate investors for assuming equity risk.

That is why I thought last week’s small retreat in the 10-year was actually meaningful. Moving from approximately 5.37% back toward 5.24% is not some dramatic change in the macro environment. But equities responded well to even that modest relief while equities went higher.

To me, that suggests the market still wants to move higher. The bond market has simply been making that move more difficult.

The five-year picture helps put the current environment into perspective. Long-term rates have moved from extraordinarily low levels to more than 5%, yet the S&P’s forward valuation has remained remarkably resilient. Today, the index is trading around 19.1x forward earnings which is roughly its 10-year historical average and actually below its recent five-year average.

I don’t look at 19.1x and conclude that stocks are obviously cheap. They aren’t. But I also don’t look at that number and see the kind of valuation excess that, by itself, requires a major market reset.

The bigger issue is what sits beside that valuation.

A 19x multiple when the 10-year yields 2% is one thing. A 19x multiple when the 10-year yields more than 5% is something very different.

That is why the next variable matters so much. Earnings.

2. Earnings Are Now Carrying More of the Market

One of the easiest narratives to repeat right now is that stocks are expensive.

There is some truth to that, especially in parts of technology and speculative growth. But valuation without earnings context only tells part of the story.

Corporate earnings have been incredibly strong.

Heading into the third-quarter reporting season, S&P 500 earnings growth is expected to exceed 35%. Strong earnings revisions have been one of the biggest reasons the market has been able to absorb the rise in interest rates without experiencing significant multiple compression.

This is where the relationship between rates and earnings becomes especially interesting.

At approximately 19.1x forward earnings, the S&P’s forward earnings yield is roughly 5.24%. The 10-year Treasury is also sitting around 5.24%.

I would not treat that as a complete valuation model. A Treasury security and an ownership stake in hundreds of businesses are very different assets. Stocks have growth, dividends, pricing power and the ability to compound earnings over time.

But the comparison illustrates the current environment perfectly.

If an investor can earn more than 5% in Treasuries, why accept the uncertainty of equities?

The answer has to be growth.

Corporate earnings have to keep increasing.

If earnings continue moving higher, the market can rise without requiring the valuation multiple to become dramatically more expensive. A higher S&P price accompanied by higher forward earnings can leave the actual P/E ratio relatively stable.

That is probably the cleanest path to another leg higher.

Not investors suddenly deciding that 22x or 24x earnings is acceptable with a 5% Treasury yield.

Instead, earnings estimates continue climbing and eventually catch up with price.

That is the second chart I would pay very close attention to over the next few months.

I care less about whether a company beats the quarterly consensus estimate by three cents than I do about what happens to the next four quarters of expectations after the earnings call.

Are analysts raising estimates?

Are margins expanding?

Is revenue growth accelerating?

Is management increasing guidance?

Is capital spending producing measurable returns?

Those are the things that can keep the forward earnings curve moving higher.

The danger is the opposite scenario.

If forward earnings estimates begin rolling over while the 10-year stays above 5%, the market suddenly has far less support. At that point you could have both parts of the valuation equation working against equities: weaker expected earnings and an attractive risk-free alternative competing for capital.

That is why this earnings season feels more consequential than the average one.

The market has handled higher rates remarkably well.

Now companies have to prove why.

3. The Next Few Weeks Should Tell Us a Lot

The timing makes this particularly interesting because we are entering one of the most important stretches of earnings and macro data of the quarter.

Major banks begin reporting this week, including JPMorgan, Goldman Sachs and Wells Fargo, followed by Bank of America and Morgan Stanley. ASML reports Wednesday, and Taiwan Semiconductor follows Thursday. At the same time, we get CPI Wednesday and PPI, retail sales and jobless claims Thursday.

That gives us several different windows into the economy at almost exactly the same time.

For the banks, I’m interested in much more than whether they beat earnings expectations.

Higher long-term rates are complicated for financial companies. Depending on the structure of the balance sheet, higher yields can support net interest income. So I don’t think the simple takeaway is that higher rates equal bad bank earnings.

What matters more is what those rates are beginning to do underneath the surface.

I want to hear about credit quality. Consumer delinquencies. Loan demand. Deposit and funding costs. Commercial lending. Any deterioration in the willingness or ability of consumers and businesses to borrow.

Those bank reports should provide one of our best real-time checks on whether restrictive financial conditions are beginning to cause meaningful damage.

Then there is technology.

The AI investment cycle has become one of the primary earnings engines of this market. Semiconductors, networking equipment, power infrastructure, data centers and industrial equipment have all benefited from an enormous capital expenditure cycle.

That spending has supported earnings and justified premium valuations across a meaningful portion of the S&P and Nasdaq.

But higher financing costs make the next part of the cycle more important.

Eventually, the conversation has to move beyond how much money is being spent on AI.

The question becomes what companies are earning from it.

That makes reports from companies such as ASML and TSMC particularly valuable. Their outlooks can tell us whether advanced-node demand remains strong, whether semiconductor capital expenditure continues accelerating and whether the infrastructure buildout supporting AI is still progressing at a pace consistent with the earnings assumptions already embedded in the market.

If banks tell us the economy and consumer are still holding up, technology tells us the investment cycle remains strong, and forward estimates continue moving higher, the market could have a very good setup.

Especially if the 10-year simply stops going up.

That is really the important distinction.

I’m not looking for everything to become perfect.

I’m looking for the pressure to stop getting worse while earnings continue getting better.

4. Constructive, But Still Selective

My own view has become a little more constructive, but I’m not suddenly interested in chasing everything higher.

There are some encouraging signs.

The S&P continues to hold near its highs. Earnings remain strong. Equal-weight participation improved last week for the first time after a long stretch of weakness. The technical structure of the broader index still looks capable of supporting another leg higher.

But there are also clear reasons to remain selective.

The Russell 2000 declined last week even as the major large-cap indexes advanced, so I don’t think we have confirmation of a healthy broad-market expansion yet.

The 10-year is still above 5%.

Oil remains elevated.

Real yields are restrictive.

And the market is already assuming a lot of things continue going right.

Corporate earnings need to remain strong. Inflation needs to remain manageable enough that the Fed does not have to become materially more restrictive. Long-term Treasury yields need to stabilize rather than march toward 6%. Oil cannot create another sustained inflation shock. And the enormous amount of capital being deployed into AI ultimately needs to generate acceptable economic returns.

None of those assumptions is unreasonable individually.

Together, they leave less room for error.

That is why I’ve been comfortable carrying more cash, being selective with new equity exposure and focusing my options selling on prices where I would genuinely be comfortable owning the underlying stock.

There is very little benefit in forcing exposure simply because the index is near a high.

If earnings continue confirming the story, there will be opportunities.

If they don’t, having liquidity becomes much more valuable.

The next several weeks should help resolve some of that uncertainty.

If the 10-year stabilizes somewhere around current levels or begins moving lower while forward earnings estimates continue climbing, I think the probability of another meaningful leg higher in the S&P increases substantially.

If yields begin moving materially higher again and earnings revisions begin weakening at the same time, that would change my view very quickly.

The market has already proven that it can survive higher rates.

The next question is whether earnings can keep giving it a reason to. We will have to wait and see 🤔