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Albert Edwards, a strategist known for his clumsy views, says even returns on bonds at current levels could be enough to burst a bubble in equities.
William Vanderson / Fox Photos / Getty Images Getty Images
Interest rates rose last week as investors gained more confidence in an economic recovery. One problem: stocks may be ill-prepared for the rise.
The yield on 10-year treasury rose to 1.1% by 0.91% by the end of Monday. With the Democrats gaining control of the Senate, the likelihood has increased that Congress will approve spending at least a few hundred billion dollars more to boost the economy. This means that better growth and slightly higher inflation can occur. Yield rates reflect expectations.
‘The reason why they [rates] in anticipation of stimulus, ”said JJ Kinahan, chief market strategist at TD Ameritrade Barron’s. “Are we heading for an inflationary scenario?”
A gradual rise in interest rates is usually seen as a sign of optimism, but a sudden rise in returns – or one that the market has not yet cost to reflect – can become problematic for equities. Higher interest rates push stock valuations because they undermine the value of future corporate profits.
And valuations are currently high, a reflection of how low interest rates have fallen in historical terms. Inventories in the S&P 500 are trading on average a little less than 23 times expected earnings for the coming year, well above the long-term average of around 15 times.
“Even ten-year US yields, now just over 1%, could be enough to reach the tipping point where the stock market bubble bursts,” said Albert Edwards, world strategist
Société Générale.
The Federal Reserve is plowing money into the bond market to keep prices high and keep interest rates low to stimulate the economy, but Edwards, known for his ever-clumsy stance, said even the Fed could not stop the bleeding .
Even with the rise in returns, investors are paying an ever higher price for stocks. The
S&P 500
ended Friday with 3.3% of the closing level Monday.
Valuations, although stretched according to some, are probably not at nose blood level. At current prices, the equity risk premium of the S&P 500 – the earnings that the average share in the index yields above and beyond what investors can get to keep safe 10-year treasury debt – is at 3.27%. The premium often hangs just over 3%, indicating that valuations are not out of control.
At the same time, however, it rarely falls below 3%, and if it does, the shares often fall. Edwards says in his report that the data indicates that the yield of bonds will increase. If earnings returns on equities do not rise correspondingly, it means a smaller risk premium.
He said yields on 10-year treasury debt are likely to rise and fall, along with the Institute for the Management of Purchasing Manager, or PMI, for manufacturing. And the benchmark recently reached about 60, the highest level since 1995. It should correlate with a 1.2 percentage point increase in 10-year returns.
If rates had risen so much rapidly, without the gains in earnings that a higher PMI and a stronger economy would normally bring, stock valuations would tumble.
See rates.
Write to Jacob Sonenshine by [email protected]