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Albert Edwards, a strategist known for his pessimistic views, says that even bond yields at current levels may be enough to burst a stock bubble.
William Vanderson / Fox Photos / Getty Images
Interest rates soared this week as investors became more confident of the economic recovery. One problem: stocks may be ill-prepared for the increase.
The yield on 10-year Treasury debt rose to 1.1% on Friday, from 0.91% to the end on Monday. With Democrats gaining control of the Senate, the likelihood that Congress would approve spending at least a few hundred billion more dollars to support the economy has increased. This means that there may be better growth and slightly higher inflation. Bond yields reflect these expectations.
“Their reason [rates] are increasing in anticipation of the stimulus, ”said JJ Kinahan, chief market strategist at TD Ameritrade Barron’s. “Are we heading towards an inflationary scenario?”
A gradual upward movement in interest rates is generally seen as a sign of optimism, but a sudden rise in yields – or an increase that the market has not yet priced to reflect – can become problematic for stocks. Higher interest rates put pressure on stock valuations because they erode the value of companies’ future profits.
And valuations are high at the moment, a reflection of how low interest rates have fallen in historical terms. S&P 500 shares are traded at an average of just under 23 times the expected profit for next year, well above the long-term average of around 15 times.
“Even yields on 10-year US bonds now just over 1% may be enough to reach the tipping point where the stock market bubble bursts,” wrote Albert Edwards, global strategist at
Société Générale.
The Federal Reserve is injecting money into the bond market to keep prices high and interest rates low to stimulate the economy, but Edwards, who is known for his perennial pessimistic views, said that even the Fed may not be able to stop the bleeding.
Even with rising yields, investors have been paying an ever higher price for shares. O
S&P 500
ended Friday with an increase of 3.3% in relation to Monday’s closing level.
The ratings, although increased according to some, are not at nosebleed levels. At current prices, the S&P 500 stock risk premium – the return on earnings that the average stock in the index brings in excess of what investors could obtain from holding 10-year Treasury bonds – is 3.27% . The premium generally fluctuates just over 3%, suggesting that ratings are not out of control.
At the same time, however, it rarely drops below 3% and, when it does, stocks tend to fall. Edwards says in his report that the data suggest that bond yields are likely to rise. If stock returns did not increase correspondingly, that would mean a narrower risk premium.
He said that 10-year Treasury debt yields tend to rise and fall along with movements in the Purchasing Managers’ Index of the Institute for Supply Management, or PMI, for the industry. And that measure has recently reached around 60, the highest level since 1995. This is likely to correlate with a 1.2 percentage point increase in 10-year income.
If rates soared, without the profit gain that a higher PMI and stronger economy would normally bring, stock valuations would plummet.
Watch the rates.
Write to Jacob Sonenshine at [email protected]