Impact of Surging US Treasury Yields: US Stock PE Ratio Shrinks Significantly, Mag 7 Dominates Small Caps

Overnight, the 10-year US Treasury yield reached a new 24-year high this week, briefly surpassing 5.36% during the session and eventually closing at 5.276%. Against this backdrop, the US stock market painted a divided picture: the S&P 500 index continues to hover near its historic highs, but valuation compression, sector divergence, and extreme market concentration are unfolding simultaneously within the index.

The S&P 500 currently trades at a forward price-to-earnings ratio of about 19.3, down from 22.2 at the start of the year. The compression in valuation is significant, yet the index itself has not seen a major pullback—mainly because earnings expectations have strengthened, offsetting some of the impact from falling valuations. “Rising rates have delivered a huge impact on stocks. The P/E ratio has dropped three notches. This effect is very direct, but it’s being masked by stellar earnings performance,” said Bob Doll, Chief Investment Officer at Crossmark Global Investments.

“This is Finance 101—higher interest rates make stocks less valuable,” stated Mark Hackett, Chief Market Strategist at Nationwide Investment Management.

Small Caps Bear the Brunt, Mag 7 Become a Safe Haven

At the same time, small-cap stocks are taking a more direct hit. The Russell 2000 index is down 9% from its all-time closing high set less than two months ago, closing at 2,793.20 on Wednesday—just shy of a technical correction (a 10% drop from the high).

Keith Lerner, Chief Investment Officer at Truist Advisory Services, pointed out: “The first and most important factor behind the recent decline in small caps is the increase in long-term US Treasury yields. Rising rates are biting—it’s just that the tech sector is concealing this impact.”

The vulnerability of small caps is structural. Lerner explained: “Small-cap stocks are more sensitive to interest rates, hold more debt, and have a higher proportion of floating-rate debt compared to their large-cap peers.”

Steve Sosnick, Chief Strategist at Interactive Brokers, said: “A 2.2% second-quarter GDP growth rate doesn't necessarily lift all boats. With uneven economic growth combined with a significant climb in rates, this is a tough environment for small caps.”

Notably, even small-cap tech stocks have not been spared—the Invesco S&P SmallCap Information Technology ETF (PSCT) has fallen 10.4% since its June 30 peak.

Market Concentration Reaches Extremes: Four Companies Prop Up the Index

The resilience of large-cap indexes is largely attributable to the outsized contributions of just a few firms.

According to research from Citadel Securities, Microsoft, Nvidia, Apple, and Meta together contributed about 300 points of gains to the S&P 500 in the third quarter—over three times the index’s total gain for the period, while the other 496 companies collectively dragged the index down by 150 points.

Scott Rubner of Citadel wrote in a client note: “The stock market is not the economy, and it’s becoming increasingly obvious that the S&P 500 does not represent the average stock.”

This concentration has reached or is nearing historical extremes by several measures. Over the past month, the Dow Jones Industrial Average fell 4.2%, while the Nasdaq rose nearly 4% during the same period—the divergence vividly illustrates this polarization.

Bonds and Stocks Are Pricing in “Different Worlds”

Henry Allen, macro strategist at Deutsche Bank, issued a deeper warning in his latest report: the bond and stock markets are currently pricing in “fundamentally different macro regimes.”

The bond market has started to reflect greater inflation risk, heightened fiscal risk, and tighter policy rate expectations, with yields in many regions globally hitting multi-year highs. But the stock market has largely shrugged this off—the S&P 500 closed less than 1% off its all-time high last Friday.

Allen noted that this divergence is “unlikely to persist.” He wrote: “We are pricing in the symptoms of a new regime (like decades-high yields and wider sovereign bond spreads), but not their logical consequences (such as slower growth and rising default risks)—which, historically, have manifested as weakness in risk assets.”

Deutsche Bank listed the top five current market dislocations, concluding that if financial stress does not quickly abate (as it did after the Silicon Valley Bank episode in March 2023), risk assets will face sustained upward pressure.

Earnings Season Becomes a Crucial Test

With the third-quarter earnings season set to fully unfold next week—Wall Street heavyweights like JPMorgan Chase and Citigroup will report first—the bar for corporate earnings has been set even higher.

Crossmark’s Bob Doll expects higher interest rates to remain a headwind for stocks, especially for cyclical firms. He said, “If you are sitting on a little bit of cash, that’s okay, because I don’t think the market will shoot up in a straight line as it did in previous months.”

Since the closing high on August 13, 18 of the 25 industry groups within the S&P 500 have declined, and the equal-weighted version of the S&P 500 has dropped 5%. Sectors such as banking and real estate have seen declines of over 10%.

Whether corporate earnings can remain “superb” will determine which way the tug of war between valuations and yields ultimately resolves.