Are bond scares making sense, or is it just a false alarm? Let's finally answer that:

Interest rates like in 1987

On October 19, 1987, the Dow Jones fell by 22.6% in a single day. It remains the worst day in Wall Street history. The yield on the ten-year US bond is over 5.2%. In February it was around 4.1%. That's exactly what 1987 looked like, when the yield shot up from 7% to over 10%. Much more important than the yield level itself 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 exactly the 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 both the US government and the largest 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 grew by 39% by the end of August, without corporate earnings keeping an adequate pace. For every $100 of value, stocks earned less than $5, 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 to grow by 32% for the whole year, according to analysts. Forward P/E therefore fell from 20.4 to 19 since the end of June, below the ten-year average. Looking ahead, stocks and bonds are roughly on par, not 5 points behind as before Black Monday.

Possible problem in earnings

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

Most sensitive are companies with high debt and weak earnings. Dividend names from energy and real estate are also under pressure, because a risk-free bond now offers a similar payout. Also growth companies whose profits are expected only many years from now, because a dollar earned 10 years from now is worth less today when rates are higher.

What history says

I looked at the 5 largest rate shocks since 1987. Then the yield jumped by more than 3 percentage points and the index fell by 33%. In 1994 it was almost 3 points and a 9% drop, 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 roughly 2 years at the latest, so for the 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 smallest detail: