The pound fell sharply against the dollar and euro Monday after U.K. Prime Minister Theresa May said Britain would make a definitive break from the European Union.

The pound fell 1.23% to $1.214 against the greenback, taking sterling to the levels it traded at in October. It was down 1.11% against the euro at €1.154. Sterling was as high as $1.24 Thursday.

On Sunday, Ms. May said in an interview with Sky News that the U.K. would aim for a clean break from the EU, reiterating her intention for Britain to negotiate control over immigration in upcoming Brexit negotiations.

“Often people talk in terms as if somehow we are leaving the EU, but we still want to kind of keep bits of membership of the EU,” Mrs. May said in an interview with Sky News.

“We are leaving. We are coming out,” she added, saying that the U.K. still wanted the “best possible deal” in terms of trade.

The EU’s 27 other heads of government have said that freedom of movement for EU citizens is a requirement for access to the bloc’s single market, with is the biggest destination for British exports.

The pound plunged in October following similar comments from Ms. May at the Conservative Party conference.

On Monday, a spokeswoman for Mrs. May said the Prime Minister hadn’t ruled anything out or in.

​”She’s said she wants the best possible deal for trading with and operating within the single market,” the spokeswoman said.

Though U.K. economic data has surprised on the upside, many analysts believe the pound will continue to head lower.

Sterling is also being hit by the strong dollar, which has gained in recent months on a belief that the U.S. Federal Reserve will raise interest rates at a faster rate in 2017. The WSJ Dollar Index was up 0.24% Monday.

Morgan Stanley sees sterling falling to $1.17 this quarter, because it thinks political uncertainty will impact investment in 2017.

However, some forecasters disagree.

“We think further signs that the government is being forced toward a soft Brexit will emerge, enabling sterling to climb back to about $1.30 and €1.24 by the end of this year,” Samuel Tombs, chief U.K. economist at Pantheon Macroeconomics, said in a research note.

—Jenny Gross contributed to this article

Write to Mike Bird at [email protected]

An uptick in earnings among riskier U.S. companies is bolstering investor confidence that an epic rally in junk bonds can last a little longer.

After six straight quarters of year-over-year declines, earnings of low-rated companies increased 14% in the second quarter and 72% in the third quarter, according to Bank of America Merrill Lynch. At the same time, defaults slowed following a wave of bankruptcies in the energy sector.

Because of those factors, some investors and analysts say junk bonds— issued by companies that are often small and burdened by debt—could do much better than might be expected after such a strong year.

“From my vantage point, fundamentals are the most important thing” and “they’ve modestly improved,” said Michael Contopoulos, head of high-yield strategy at Bank of America, noting stronger earnings and steady oil prices have reduced risks.

The average junk bond yield was 5.86% Thursday, a two-year low but above the sub-5% levels it reached in 2014. Despite the low yields, many investors still view junk bonds as attractive at a time when the 10-year Treasury note yield is below 2.5% and stock valuations are widely seen as inflated.

Among the many junk-rated companies that had better earnings was Sprint Corp., which reported a 17% increase in adjusted earnings before interest, taxes, depreciation and amortization in the quarter ended Sept. 30 from a year earlier. Its 7.625% bonds due 2025 last traded at around 107 cents on the dollar, up from 75 cents on the dollar in June, according to MarketAxess.

The Bloomberg Barclays U.S. Corporate High Yield Index returned 17.1% in 2016. That was its best total return since 2009 and better than those produced by all three major stock indexes, as well as investment-grade corporate bonds and U.S. Treasurys.

Such a performance almost certainly can’t be replicated in 2017. Unlike stocks, there is a limit to how much bonds can rally because they mature at 100 cents on the dollar.

As bond prices rise, their yields decline. Before last year, junk bonds had produced double-digit returns four times in the previous 10 years and each time returns were much lower the following year.

Still, many investors and analysts are fairly optimistic about how junk bonds will perform.

Of six large banks surveyed by The Wall Street Journal, four project positive returns for junk bonds in 2017. J.P. Morgan Chase & Co. is the most bullish, predicting an 8% return. Wells Fargo & Co. is projecting 5% to 6%, while Bank of America Merrill Lynch is estimating 4% to 5% and Goldman Sachs Group Inc. is expecting 3.2%.

“High yield is a pretty resilient asset class,” said John McClain, a high-yield bond portfolio manager at Diamond Hill Capital Management in Columbus, Ohio. Though the market hit a rough patch in early 2016 as recession fears increased and sellers had trouble finding buyers, “that got fixed very quickly,” he added.

Of course, junk bonds still face risks. They are especially sensitive to economic downturns, sometimes picking up signs of stress before the stock market.

Though they aren’t as vulnerable to rising Treasury yields as investment-grade corporate bonds, junk bonds likely would decline in price if the Federal Reserve raises interest rates more quickly than expected and government bond yields increase sharply. That is especially true for higher-rated bonds with lower yields.

One wild card is the volume of new bonds added to the market. While bond sales tend to drop off during times of market stress, robust issuance can also depress prices of outstanding debt due to supply-demand dynamics.

Unlike the investment grade bonds, which set a record for issuance in 2015 and nearly matched that total last year, the volume of new high-yield bonds has declined in recent years, totaling $261 billion in 2016 compared with $269 billion in 2015 and a record $359 billion in 2013, according to Dealogic.

Perhaps this rally hasn’t ended. Perhaps it has just begun.

The Dow Jones Industrial Average on Friday closed at 19963.80, as it nears 20000 and extends an upswing that began in the depths of the financial crisis. When it arrives at 20000, it will be the Dow’s 14th thousand-point milestone since then and the second-fastest on record.

The stock rally ranks among the least-beloved in history, traders and analysts say. The technology bust and the financial meltdown taught individuals to shy away from stocks and to embrace bonds and cash. Investors poured $381 billion into bond mutual and exchange-traded funds between the start of 2014 and October, according to EPFR Global. Over the same span, they pulled a net $16 billion from stock funds.

It is a strategy that many have pursued to their detriment. The Dow has returned 274%, including price gains and dividends, since its 2009 bottom. The 10-year​U.S. Treasury note has returned 33% over the same span. Now, with many on Wall Street raising their estimates for U.S. economic growth in coming years following the surprise election of Donald Trump, swapping out of bonds for stocks is an idea that is coming up more in conversation.

“People are saying, is it safe to get in now” to the stock market, said James D. McDonald, chief investment strategist at Northern Trust Corp. in Chicago, with $946 billion in assets under management.

Some analysts view this underinvestment as a tailwind for stocks, which they also contend look relatively attractive to many other investments based on measures such as corporate earnings, dividend yields and the economic outlook. While the U.S. economic expansion already ranks among the longest on record, few see signs that a slowdown is imminent. And if investors gain confidence, they could pour money into stocks and drive major indexes still higher.

For now, “people still feel the market going up is temporary and speculative,” said Richard Bernstein, chief executive of Richard Bernstein Advisors, a New York investment adviser with $3.1 billion in assets under management.

Roughly 46% of investors were bullish as of Jan. 4, according to the weekly survey by the American Association of Individual Investors. That is above the long-term average of 38% but far below the peaks of 75% reached in January 2000 and 58% in 2007. Investors often use the survey as a contrarian indicator, selling when bullish sentiment reaches highs and buying when bearishness spikes.

One investor who embodies these conflicting impulses is Al Tomei, a 75-year-old from Los Angeles who retired as a facilities planner for the Los Angeles Unified School District.

He maintained a split portfolio of half bonds and half stocks as recently as 2007, when the Dow peaked above 14000 before losing more than half its value in the financial crisis. The Dow lost 32% on a total-return basis in 2008.

Since then, Mr. Tomei has kept about 80% of his portfolio in bonds. He is now thinking about moving back toward a 50-50 split, concerned that Mr. Trump’s plans to increase fiscal spending and cut taxes will boost inflation, chipping away at the value of bonds’ fixed payments. The Dow’s total return was 16% in 2016, roughly half of that since Mr. Trump’s Nov. 8 election.

Mr. Tomei worries that stocks are due for a correction after the gains of the past year, which he views as being fueled by external factors such as stock buybacks and central- bank stimulus rather than fundamental improvements in the U.S. economy. He is holding 4% to 5% of his assets in cash for now and looking for opportunities to buy stocks cheap.

“Everything I’ve read is that stocks are richly priced and when they’re richly priced, the odds of them going higher are not particularly good,” said Mr. Tomei.

Valuations are indeed stretched relative to history, said Messrs. Bernstein and McDonald. Stocks in the S&P 500 traded Thursday at roughly 21 times their past 12 months of earnings, up from a 10-year average of 16, according to FactSet. But they say the valuations aren’t extreme given how low interest rates remain relative to history, a condition that tends to push investors into stocks as a higher-yielding alternative, while keeping borrowing costs low for companies.

Bond yields have surged by more than a percentage point since hitting all-time lows this past summer, with the 10-year Treasury yield rising to 2.417% on ​Friday.

The dividend yield on the S&P 500 was roughly 2% Friday, according to S&P Dow Jones Indices. That makes stocks competitive with bonds as a source of income, while offering greater potential for asset appreciation, several investors said.

Other metrics look relatively good for stocks as well. Corporate earnings, a major driver of stock-price gains over time, have begun rising after a sharp decline during the 2014-2016 energy bust. Strong earnings growth can mitigate valuation concerns, Mr. Bernstein said. Analysts expect S&P 500 earnings to rise 11% from a year ago in the first quarter, according to FactSet.

Mr. Bernstein said his firm began buying cyclical stocks such as energy, materials, technology and financial firms in the first quarter of 2016, when market-based inflation expectations began rising. He said Mr. Trump’s promise of fiscal stimulus “creates an almost unprecedented” stockpile of fuel for further stock gains. Stimulus plans typically are enacted at an earlier stage of the economic cycle when unemployment is higher. Mr. Bernstein said: “4.7% joblessness plus fiscal stimulus—whoa! That hasn’t happened in my career.”

Mr. McDonald of Northern Trust said he saw signs of improving global growth starting in May, when purchasing managers’ reports began showing signs of renewed strength.

His firm sharply increased its stockholdings after Mr. Trump was elected in November. Mr. McDonald said he believed Republican control of Congress would enable the new administration to play a more constructive role in facilitating economic growth than has happened in years of mostly divided government. He also said he believes the election has had a confidence-boosting effect throughout the economy.

Yet some remain unconvinced, scarred by the financial crisis and concerned that both stocks and bonds remain expensive. Many investors are holding cash, “waiting for the market to fall or worried about investing because they believe prices are too high,” said Eric D. Nelson, managing principal at Servo Wealth Management, an investment adviser in Oklahoma City. “Honestly, I can’t remember the last time I encountered an investor who is fully invested.”

Write to Colin Barr at [email protected] and Aaron Kuriloff at [email protected]