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Albert Edwards, a strategist known for his bearish views, says even bond yields at current levels could be enough to blow up a stock bubble.
William Vanderson / Fox Photos / Getty Images Getty Images
Interest rates soared last week as investors gained more confidence in the economic recovery. One problem: stocks may be ill-prepared to increase.
The 10-year Treasury debt yield rose to 1.1% on Friday, from 0.91% to the end of Monday. With Democrats gaining control of the Senate, it has increased the likelihood that Congress will approve spending at least a few hundred million dollars more to sustain the economy. That means better growth and slightly higher inflation could grow. Bond yields reflect these expectations.
“The reason why [rates] “Growth is expected to stimulate,” said JJ Kinahan, chief market strategist at TD Ameritrade De Barron. “Are we heading for an inflationary scenario?”
A higher gradual move in interest rates is generally seen as a sign of optimism, but a sudden rise in yields (or that the market does not yet have a price to reflect) could become problematic for equities. Higher interest rates pressure stock valuations because they erode the value of future corporate profits.
And at the moment the valuations are high, which reflects the drop in interest rates in historical terms. The shares of the S&P 500 are trading at an average of just under 23 times the expected earnings for next year, well above the long-term average, about 15 times.
“Even ten-year US bond yields now just above 1% could be enough to reach the turning point where the equity market bubble bursts,” wrote Albert Edwards, world strategist of
Societe Generale.
The Federal Reserve throws money into the bond market to keep prices high and interest rates low to stimulate the economy, but Edwards, who is known for his perennially bearish views, said even the Fed could not be able to stop the bleeding.
Even with rising returns, investors have been paying an ever-higher price for stocks. He
S&P 500
ended Friday at 3.3% from Monday’s close.
Assessments, although widespread according to some, are probably not at nasal bleeding levels. At current prices, the S&P 500 equity risk premium — profits generate an average stock of the index that exceeds what investors could get if they kept a 10-year Treasury debt safe — is at 3, 27%. The premium is often above 3%, suggesting that valuations are not out of control.
At the same time, however, it rarely falls below 3%, and when it does, stocks often fall. Edwards says in his report that the data suggests that bond yields will grow. If the returns on the profits of the shares did not increase accordingly, this would mean a lower risk premium.
He said 10-year Treasury debt yields tend to rise and fall along with the Purchasing Manager’s Index of Supply Management (PMI) purchases for manufacturing. And this measure has recently reached 60, the highest level since 1995. This should correlate with a 1.2 percentage point increase in ten-year performance.
If rates soared rapidly, without the profit gain that would normally generate a higher PMI and a stronger economy, stock valuations would fall.
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Write to Jacob Sonenshine to [email protected]