By Matt Koppenheffer
The current rally in stocks could hit a brick wall, and it may have very little to do with Greece, Citigroup, financial reform, or China's refusal to revalue the yuan.
Over the past three decades, falling interest rates have made stocks increasingly attractive even at higher valuations. The reason is pretty simple. When safe, secure government bonds produce yields above 15% -- which they did in late 1981 -- even a stock with an earnings yield of 10% may not seem all that attractive. However, when long interest rates are hovering below 4%, then investors may be ready and willing to jump on stocks with earnings yields of 5% and 6%.
Because earnings yield is the inverse of the much-watched price-to-earnings ratio, then by definition when investors are willing to accept lower earnings yields, they are also accepting higher P/E ratios.
Considering that 10-year Treasuries currently yield a hair over 3.9%, it shouldn't be too surprising that many stocks -- not to mention the broader markets as a whole -- are sporting hefty valuations.
While Google, Schlumberger, and Berkshire Hathaway are all still trading below their late-2007 levels, Apple has blown through its pre-crisis highs. Visa, meanwhile, wasn't a public company until early 2008, but it's trading at all-time highs. And while most of these companies are expected to deliver solid growth going forward, investors may start demanding more current yield out of them if Treasuries start to provide more competition.
Rates on the key 10-year Treasury have already leapt back up from their 2008 lows of right around 2% to today's 3.9%. If rates continue to rise, investors will (or at least they should) begin looking for higher returns from the stocks they purchase, which means lower valuations. As I noted above, growth can help with this, but in many cases that might not be enough and investors may also demand lower prices.
Rally, meet brakes.
But will yields really rise?
There's a lot of debate over the future of Treasuries, but there are some very compelling reasons to believe that the next few years could bring a marked increase in Treasury yields.
1. Government deficits. Right now, the U.S. government is running a massive fiscal deficit. Though there's a lot of jawboning about moving toward a balanced budget, a cynical observer like yours truly would say that Washington seems to be long on talk and short on the political will needed to cut spending.
These deficits will force the government to raise more debt. And as any Economics 101 student can tell you, when you flood the market with supply, you typically see prices drop. In the bond market, falling prices mean rising yields. But don't take it from me -- in his recent investment outlook, PIMCO's Bill Gross pointed out the same: "high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation ..."
2. Federal Funds Rate. I don't want to overstate the power of the Federal Funds Rate or suggest that the Fed Funds Rate and Treasuries move in perfect tandem -- because they don't. However, by manipulating rates, the Fed does tend to exert some directional control over rates of Treasuries and other paper.
With the Federal Funds Rate currently hovering just above 0%, the Fed doesn't have much of a choice when it comes to the direction of its next move. The change may not be next month, and it may not even be in three months, but when the Fed does make its next move, that move will be up.
3. No longer at the edge of a cliff. During the worst of the financial crisis, investors around the world piled into U.S. Treasuries as a safe haven. Yes, this happened despite the fact that the financial crisis began in the U.S. (maybe we can chuckle about this in a few years).
But now that global investors have changed their underwear and taken a deep breath, their risk appetite will start to return. And as risk appetites awaken again, Uncle Sam may find he has to offer better yields to attract buyers.
There are two primary ways to deal with the specter of rising yields. First, having some cash on the sidelines will allow you to take advantage of better valuations if higher yields do end up putting pressure on the stock market.
Past that, it's important to keep a close eye on valuations. Stocks like UnitedHealth's (NYSE: UNH) and Lockheed Martin's -- both of which have trailing earnings yields well above 9% -- would likely feel less pressure if government bond yields do rise. Companies like Southern Company (NYSE: SO) and Kinder Morgan Energy Partners could also be good bets because their dividend yields are competitive with Treasury yields and they have shown a propensity to raise their dividends.
But while we may be able to say a lot of things about the future of Treasuries, one thing we can't say is that the situation is black and white. So why not chime in with what you think? Scroll down to the comments section and share your thoughts.