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Swollen Valuations May Deflate as Bond Yields Top Out

The combination of an earnings recovery and a rebound in bond prices could signal a time to exit large-cap growth giants.

Sure the market's overvalued. There's nothing new in that. But with the

Federal Open Market Committee

apparently set to raise rates as it meets today and tomorrow, it may be about to get cheaper, for some less-than-obvious reasons.

The price-to-earnings ratio of the

S&P 500

-- everybody's favorite back-of-the-envelope valuation measure -- has been above 20, based on trailing earnings, since mid-1997 and is now around 29. The S&P 500's P/E went above 20 on just two other occasions in the past 15 years. In one case when this happened, in the winter of 1992, the index didn't go much of anywhere for the next six months. The other time it happened was in the months leading up to the 1987 market crash.

The more sophisticated models many Wall Street strategists employ, based on the earnings yield relative to the long bond's yield, have been showing stocks overvalued by more than 30% for much of this year. This is something that's happened just twice before in the past 15 years -- in the winter of 1992 and in the months leading up to the 1987 market crash.

None of this is very comforting. As

J.P. Morgan's

Doug Cliggott, one of the strategists who use the latter type of model, wrote in a recent report, "At best, we think the current stretched valuations imply a prolonged period of very sluggish gains by the major market indices. And the risk of a less favorable near-term outlook seems pretty high."

The notion behind valuation models like Cliggott's is that bonds will offer a more attractive return than stocks when the S&P's value, earnings for S&P companies and the yield on the 30-year Treasury converge at a certain point. With the expectation of a Fed rate hike, bond yields have been climbing, and as yields have climbed, stocks have become more and more overvalued. When Cliggott first went underweight stocks in early February, he said that stocks were rich by 16%. Friday, they were rich by 37%.

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Watching for the End of Bonds' Slide

Those rising yields haven't really damaged the S&P all that much, though. The S&P 500 has put in a 4.7% gain since Cliggott's February call -- modest by recent standards but still a gain. And in a way, this makes sense. As attractive as the bond yields may have been relative to stocks, asset allocators would have been foolish to sell stocks for bonds over the past five months. Bonds have been heading lower.

But what happens when bonds stop falling? When they stabilize or start moving higher? Because people are talking like that's going to happen soon, if it hasn't happened already. Bonds have already priced in, by some counts, more than two Fed hikes. "I don't think rates are going to go up a whole lot more than this," says Byron Wien, chief U.S. investment strategist at

Morgan Stanley Dean Witter

, whose model, like Cliggott's, shows stocks "more than 30% overvalued."

Oddly, it may be when bonds yields find their top that the S&P runs into trouble. It's then that asset allocators will feel comfortable taking advantage of high yields and start favoring bonds over stocks.

The early-1992 experience is instructive. It was the beginning of an upswing in earnings and a downturn in bond yields -- two things that one would normally consider bullish for the market. But it was also the beginning of a tough slog for stocks, when the S&P 500 didn't get very far and valuation measures came back in line.

A Time to Avoid the Big Boys

But although the S&P 500 may not get anywhere during a period where valuations come back in line, it's not necessarily a bad time for investors -- so long as they are not big in the large-cap growth names that dominate the market-cap-weighted index.

While the valuation of the index has been heading through the roof, says Stanley Nabi, chief investment officer at

DLJ Investment Management

, "there has been an internal correction in the market now for almost 18 months. You have had a few dozen stocks that are up in P/E, but the general market P/E has been down."

With yields high and earnings recovering, cash is due to start coming out of those high P/E stocks, according to Cliggott. "Not only do you have high P/Es and interest rates pushing money away from growth stocks," says Cliggott, "but you have a magnet on the other side -- high earnings attracting money into economically sensitive stocks."

But Treasury yields topping out may be a necessary catalyst before this process can really begin. There's a sense on Wall Street that the turn is very near. "That's the next trade -- to buy bonds and not stocks," says Cliggott, who went underweight bonds in late August. "We're waiting for a bit higher yield. We're almost there, and maybe we're being stupid by not going there now."