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Bond rout eats into the one remaining valuation case for stocks

Traders work on the floor of the New York Stock Exchange (NYSE) on Friday, Nov. 11.

Michael Nagle/Bloomberg

The sell-off in debt that sent 10-year Treasury yields to the highest levels since January threatens to make an already richly priced stock market look downright expensive.

That's because of its effect on a valuation framework known as the Fed model, which says it's OK to own equities as long as their prices compare favourably with bonds. The comparison plots S&P 500 Index earnings expressed as a percentage of price, now 4.9 per cent, against Treasury rates. Spiking bond yields have narrowed the advantage enjoyed by stocks to the least in three years.

While not everyone considers it valid, the Fed model had been one of the last remaining lenses through which stocks looked cheap at a time when the S&P 500 trades above 20 times earnings. Stocks might be outpacing earnings growth, the argument goes, but as long as bonds are rallying faster, investors would be justified in sticking with the less-inflated asset.

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"Trump is talking about very inflationary measures with new debt coming on, borrowing, etc., so bond yields have spiked -- it absolutely complicates valuations," Steven DeSanctis, a research analyst at Jefferies LLC, said by phone. "The inflation picture is important. It's a little early to finally see that rotation between stocks and bonds but we're tracking fund flows on a weekly basis so we can see what actually happens."

The S&P 500 added 0.3 per cent to 2,171.21 by 10:18 a.m. in New York on Monday as the 10-year note yield jumped 11 basis points to 2.26 per cent, the highest it's been all year. The selloff wiped a record $1.2-trillion off the value of bonds around the world last week and sent 30-year yields above 3 per cent for the first time since December, while major stock gauges rallied the most in at least two years.

Going by the Fed model, a record low of 1.36 per cent on the 10-year yield in July and an earnings yield of about 5 per cent on the benchmark gauge meant the gap between the two was wider than about 70 per cent of the time since 2000, according to data compiled by Bloomberg. That spread has now dropped to 2.7 percentage points, the smallest in almost three years.

While the Fed model is simply a mathematical tool to compare returns, the surge in bond yields could have real implications on the forces that have driven an equity market that's more than seven years old. As yields rise, dividend-paying companies that have lured investors for their regular income could become less attractive.

Stocks and bonds have been moving in the same direction just about all year. With the S&P 500 up this month amid a rout in the Barclays bond index, the two asset classes are diverging for the first time in eight months, ended a run of synchronized moves that has only happened a handful of times since 1976.

Still, while yields are surging, they're doing so off very low levels. Bonds have a lot more selling to do before they're offering enough to draw investors away from high-yielding equities, according to Charles Schwab & Co's Jeffrey Kleintop.

"Historically, over 5 per cent on the 10-year is where rising interest rates become an impediment to valuations," Mr. Kleintop, chief global investment strategist at Schwab, said in an interview on Bloomberg Television. "Below that it's actually correlated to higher stock prices. Rising interest rates means better economic activity, better inflation and are good for stocks."

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Investors on Monday assessed a stronger dollar and declines in oil, while the global debt selloff intensified. Stocks have outperformed bonds since Donald Trump's election win, on speculation his pledge to spend more on infrastructure will trigger interest-rate hikes amid a pickup in growth and inflation. Equities had their biggest inflows in 17 weeks as bonds saw redemptions, for their largest gap in 12 months, a Bank of America Corp. report on Thursday showed.

"There's a lot of re-positioning going on in the market rather than the whole market rolling over, with the sectors expected to do well under Trump outshining those which should fare worse," said Jasper Lawler, a London-based analyst at CMC Markets Plc. "We are starting to see a reallocation according to the fiscal policy."

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