Core Concern for Stock Bulls Is If Yields Zap Earnings Miracle

(Bloomberg) -- For stock bulls, it’s simple. Could rising rates on Treasury bonds reduce or even eliminate the benefits of some of the fattest corporate profits ever reported?

U.S. earnings were a record in the first quarter -- $300 billion in the S&P 500, something that by itself made equities a lot less expensive. But factor in higher rates, and the advantage could quickly disappear. U.S. futures slipped Thursday as 10-year Treasury yields climbed to 3.10 percent.

“This is the eternal question: How long can the market move higher with these yields?” said Quincy Krosby, the chief market strategist at Prudential Financial Inc. “We’re not there yet, but the market is always looking ahead, and that suggests that we’re going to get to a point where it becomes more attractive to keep money in cash.”

One way of looking at this is the Fed model, which compares the value of stocks and fixed income. It inverts P/Es, expressing profits as a yield like bonds pay, and uses it to frame their relative expensiveness. Right now, the S&P 500’s earnings yield is 4.8 percent, comfortably above the 10-year Treasury yield of 3.08 percent. But the gap of 1.7 percentage points is just about the same as existed the Friday before the February volatility blowup. It’s also 40 basis points less than the difference at the start of the year.

By that measure, rising rates have detracted from the allure earnings should have provided for stocks. Coming into earnings season, companies were set for the best profit increase in seven years with projected growth of 17 percent. They did significantly better, with profit growth upwards of 20 percent and almost 80 percent of companies beating estimates.

That’s brought price-earnings ratios back to earth. At 20.9 times reported earnings, the S&P 500’s multiple is down from its December highs above 23. But even with projected positive earnings growth through the next two years, investors are erring on the side of caution, looking for hard evidence companies will deliver. The S&P 500 has been pretty much range-bound since the correction, confined within its 100- and 200-day moving averages before barely breaking out late last week.

“To me that’s a positive sign, the market hasn’t broken down, but it’s trying to figure out: what is that trade-off between potentially higher interest rates and earnings?” David Joy, chief market strategist at Ameriprise Financial Inc, which manages about $887 billion, said in an interview at Bloomberg’s New York headquarters. “The market is struggling with conclusive evidence that the economy is strong enough to deliver that earnings growth that the market is looking for.”

A 10-year Treasury yield pushing towards three percent was partially to blame for the selloff in late January, as hints of inflation emerged in the wages component of a payrolls report. Since then, inflation has remained in focus, oil prices have risen above $70 a barrel, and the 10-year yield has broken through to levels not seen since 2011.

“We came into the year thinking that the 10-year would rise, but it’s blown through our forecast already,” Joy said. “The market is struggling with that a little bit trying to figure out where it’s going to settle.”

It would take a 10-year Treasury yield just under five percent to erase the gap set out by the Fed model. It won’t get there anytime soon, according to Pacific Investment Management Co., who sees 10-year Treasury yields staying under 3.5 percent this year. Plus, many equity investors feel safe as long as the S&P 500 earnings yield remains a comfortable distance above Treasury rates.

And while many view the Fed model as a way to gauge relative value, the method of comparing earnings yields to that of Treasuries isn’t unanimously accepted by professionals. Among the caveats: corporate earnings and bond yields move with different volatility and sensitivity to inflation. But it’s a practical way to measure relative valuation as the Federal Reserve raises interest rates after years of easy money.

“For years nobody mentioned the Fed model because the math didn’t work. So in 2007, everybody thought it was the perfect model, and then the wheels came off the bus,” said Russell Price, Ameriprise Financial’s senior economist. “It’s interesting now that you can go back to the Fed model and now it makes more sense.”

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