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Albert Edwards, a strategist known for his bearish insights, says even bond yields at current levels could be enough to burst a bubble in stocks.
William Vanderson / Fox Photos / Getty Images Getty Images
Interest rates rose last week as investors gained confidence in an economic recovery. One problem: stocks may be ill-prepared for the rise.
The yield on 10-year Treasury bonds rose to 1.1% on Friday, from 0.91% to the end of Monday. Now that the Democrats have gained control of the Senate, there is a greater chance that Congress will approve that at least an additional several hundred billion dollars will be spent to support the economy. That means that there could be better growth and slightly higher inflation. Bond yields reflect those expectations.
‘The reason why [rates] are peaks in anticipation of stimulus measures, ”said JJ Kinahan, chief market strategist at TD Ameritrade Barron’s. “Are we moving towards an inflationary scenario?”
A gradual rise in interest rates is generally seen as a sign of optimism, but a sudden rise in yields – or one that the market hasn’t yet priced to reflect – could become problematic for stocks. Higher interest rates put pressure on the valuation of stocks as they erode the value of future corporate profits.
And valuations are currently high, reflecting historically low interest rates. Shares in the S&P 500 trade on average just under 23 times their expected earnings for the coming year, well above the long-term average of about 15 times.
“Even the US 10-year bond yields now just above 1% could be enough to hit the tipping point where the stock market bubble bursts,” wrote Albert Edwards, global strategist.
Societe Generale.
The Federal Reserve is plowing money into the bond market to keep prices high and interest rates low to stimulate the economy, but Edwards, who is known for his eternally bearish stances, said even the Fed may not be able to stop the bleeding.
Even with the increase in yields, investors are paying increasingly higher prices for stocks. The
S&P 500
ended Friday 3.3% higher than Monday’s closing level.
Ratings, while stretched according to some, are arguably not at the level of nosebleeds. At current prices, the risk premium on shares of the S&P 500 – the profit generated by the average stock in the index is more than what investors could get by holding safe 10-year Treasuries – 3.27%. The premium often fluctuates just above 3%, suggesting valuations are not getting out of hand.
At the same time, however, it rarely dips below 3%, and when it does, stocks often fall. Edwards says in his report that data indicates bond yields will rise. If the earnings on equity did not increase accordingly, it would mean a lower risk premium.
He said yields on 10-year Treasury bonds tend to rise and fall, along with movements in the Institute for Supply Management Purchasing Manager Index, or PMI, for manufacturing. And that measure recently hit about 60, the highest level since 1995. That should correlate with a 1.2 percentage point increase in 10-year revenue.
If prices rose so fast, without the earnings gains that a higher PMI and stronger economy would normally yield, stock valuations would fall.
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Write to Jacob Sonenshine at [email protected]