Stocks at a record, but bonds look to break bad first

NEW YORK Thu Jun 5, 2014 1:11am EDT

A flag is seen outside the New York Stock Exchange in New York, January 4, 2013.  REUTERS/Eric Thayer

A flag is seen outside the New York Stock Exchange in New York, January 4, 2013.

Credit: Reuters/Eric Thayer

NEW YORK (Reuters) - U.S. stock and bond markets have risen in tandem all year as investors in each found reasons to support their views: stocks are up on signs the economy is improving, and bonds have gained on expectations for low inflation and relatively slow growth.

The benchmark Standard & Poor's 500 set multiple records in the last few weeks, while the Barclays U.S. Aggregate Bond Index .BCUSA is up 3.3 percent this year, having also hit a record. However, the rally in yields that brought the benchmark 10-year bond to its lowest level in nearly a year last week has some investors saying it may be the bond market that's gone too far.

"It's a bit head-scratching," said Bob Doll, chief equity strategist at Nuveen Asset Management with $120 billion in assets under management. "To me there are signs everywhere the economy is about to get better, and we won't know it until we get second-quarter GDP. Inflation is not going to be high but unlikely to be as low at the end of the year as it was at the start of the year.

"When these other things fade away, my view is we could get a quick move up in rates."

Signs that investors are starting to cotton to this are emerging. Stronger-than-expected U.S. economic data, including on recent inflation, has stemmed some of the enthusiasm for Treasuries. The 10-year yield hit 2.60 percent on Wednesday, highest since mid-May.

And some strategists say the bond market has been unnaturally bolstered by sinking yields in key bond markets in Europe, where the central bank is still ramping up monetary stimulus, as well as by buyers such as pension funds seeking to lock in 2013's equity gains. In Asia, Chinese growth is slowing, while Japan is easing its monetary policy.

CUTTING OFF THE RALLY

Since the 2007-2009 recession, the Federal Reserve has effectively printed about $3 trillion. It has kept interest rates near zero for more than five years, and new Fed chair Janet Yellen said the U.S. central bank will keep them there for a considerable time even after it ends its bond-buying program.

"We are in a period of low economic growth with little inflation and that's good for fixed income markets," said Gary Pollack, head of fixed income trading at Deutsche Bank Private Banking in New York. "It's also good for equities because they don't have to worry about the Fed raising rates any time soon."

However, the Fed is reducing monthly bond buying, and the April-May bond-market rally that saw the 10-year drop nearly 0.40 percentage point raised concern that the Fed's reduced support would hurt economic growth.

Other outside forces are at least partially responsible for the bond market's rally, investors said.

The European Central Bank is on the verge of introducing more stimulus that has driven down yields on Europe. Investors seeing 10-year rates below 3 percent in economies such as Spain and Italy have instead shifted to the U.S.

"What bonds are telling us is that the typical U.S. cyclical framework for analyzing rates is no longer valid," said Krishna Memani, chief investment officer at OppenheimerFunds in New York, which has about $245 billion under management. "Outside forces should continue to depress U.S. rates even as the U.S. economy and corporate earnings growth gather momentum."

VALUATIONS FAVOR STOCKS

Rather than see U.S. yields go lower, big investors expect that healthier U.S. economic data will slow the rally in bonds while stocks won't suffer a catastrophic tumble.

The S&P 500 .SPX is on track for another record year. In the last five years, the U.S. stock market has seen its longest rise without experiencing a decline of more than 10 percent. That's been a concern - but some worrisome areas of the market including Internet retailers and biotechnology have sold off dramatically since the beginning of the year.

These market gains have pushed the S&P 500's valuation toward the upper end of its historical range. The S&P 500's 12-month forward price-earnings ratio is currently 15.4, about on par with the average since 2000, but bonds - both government and corporate - are way richer.

The gap between the U.S. 10-year and the S&P 500 earnings yield (computed by dividing estimated S&P earnings by the price of the S&P) has widened to about 3.90 percentage points, compared with about 3.50 at the start of the year. The 10-year is at about 2.60, and the S&P's earnings yield is around 6.48 percent.

That's an enormous gulf - the long-term mean is about 1.43 percentage points - and it shows how investors are not being compensated for the risk in bonds.

"At current levels, traditional bonds in particular offer little value," said Russ Koesterich, chief investment strategist at BlackRock in New York, which has about $4.3 trillion under management. "We don't expect a big selloff in bonds, causing rates to sharply climb back up, but overall, we continue to favor equities over bonds, even as stocks continue to move toward new highs."

(Additonal reporting by Jennifer Ablan. Editing by David Gaffen and John Pickering)

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