No Rest for Weary Stock Players: The Bonds Are in Control

With lots more economic data coming and pre-FOMC jitters widespread, Wall Street will spend next week again watching interest rates.
Author:
Publish date:

There are people on Wall Street who spend lots of time building models of how stocks should be valued in light of where Treasuries are trading. This has lately been a pretty fruitless occupation.

The basic idea behind these models is simple. Treasuries represent a risk-free investment. Buy a 30-year Treasury bond now, and you'll get 5.8% every year, guaranteed. Stocks are not a risk-free investment. Sometimes they go down. Sometimes, you lose your shirt. If you buy a stock now, you are doing it in the expectation that you will get a substantially better return than you do on a Treasury. That's why you're taking that risk.

But with the price-to-earnings ratio on the

S&P 500

at about 29, and earnings over the next year expected to be good but not great, valuation models are nearly as stretched as they've ever been. It's enough to make someone pull his hair out.

Morgan Stanley Dean Witter

chief investment strategist Byron Wien (and you thought he

shaved

his head) wrote back on Monday, when the yield on the long bond was 5.66%, that the

S&P 500

was "30% overvalued, well above the 20% level that has generally triggered corrections in the past. At 6% yields, it would be 37% overvalued, close to the highest level my valuation model has reached in the past 20 years -- in 1987, just before the sharp decline that year."

A yield of 6% is the line many people on Wall Street have been drawing as a danger level, the place where complacency ends and the stock market runs into a rough patch. Indeed, with the Treasuries having broken out of the range that held the yield below 5.7%, the stock market is has begun to get pretty nervous, and that nervousness will not subside in the coming week. Like it or not, the bonds are in control.

"If long rates get to 6%, it's going to be a big question mark for the stock market," said Rao Chalasani, chief investment strategist at

Everen Securities

in Chicago. "It would have a hard time making any headway. In fact, it would probably go down."

Given that danger, Chalasani is sticking with what has really been the market's theme lately -- going into the stocks of companies whose businesses are closely linked to the world economy, and getting out of the growth stocks people fled to when the world economy was on the rocks.

"What you really want to be careful with is growth at any price," he said. "That's what's really problematic at this time." But he worries that not just growth but the broader market, and the recent broadening of the market, will get hurt if rates continue to climb.

Unfortunately for the stock market, things have been looking pretty grim for the bonds. Friday, even after the April

jobs report

came in lighter than what economists expected, and far more benignly than what the market feared, the Treasuries fell under pressure. When something can't rally on good news, it's a good sign that the bears are in charge.

One of the problems for the Treasury market is that there's going be a glut of supply. The coming week marks the quarterly refunding, when the

Treasury Department

auctions off longer-term Treasuries. On Tuesday, it will put $15 billion in five-year notes on the block, and on Wednesday $10 billion in 10-year notes go on sale. With so much nervousness about the

Federal Open Market Committee

meeting the following Tuesday, it may be difficult for the market to deal with the supply challenge.

Following the auction, it's on to the data. Thursday the April

retail sales

figures and

Producer Price Index

get released. Friday brings the April

Consumer Price Index

. The two inflation reports -- the PPI and the CPI -- are important, but retail sales will get the most attention since it will play an important role in fleshing out second-quarter

gross domestic product

.

Writ large over the week will be the debate over what the FOMC is thinking these days. The signals are very mixed. Friday, two reporters who are seen as having close ties to Fed officials,

The Washington Post's

John Berry and

Market News'

Steven Beckner, came out with essentially contradictory articles on what Fed Chairman

Alan Greenspan's

Thursday speech -- which the bond market took as an indication the Fed was moving toward a tightening bias -- was really about.

In a front page

piece, Berry wrote:

The Fed chairman's sweeping assessment indicated that he believes the U.S. economy can continue to grow, within some limits, more rapidly than in the past without causing inflation to increase. That assessment, which is shared by many but not all of his Fed colleagues, also suggests that the central bank is unlikely to raise short-term interest rates as a result of the strong economic growth so far this year.

But Beckner's

article led off with this:

It was almost surely no accident that Federal Reserve Chairman Alan Greenspan's speech Thursday to a Chicago Fed banking conference had the effect of pushing long-term interest rates higher, Fed sources say. It is very unlikely Greenspan was either surprised or disappointed by the bond market selloff his remarks precipitated, said the sources. Although there is, as yet, scant evidence of accelerating inflation -- and no immediate inclination by Greenspan or most of his colleagues on the Federal Open Market Committee to tighten monetary policy -- the Fed chairman's views reflect a growing trepidation about potential inflation pressures among FOMC members, sources indicated.

Confused? So's the market. And at least one of these writers.