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Bond-Yield Rebound Poses a Threat to Stock Rally

The Wall Street Journal. logo The Wall Street Journal. 3/20/2017 Aaron Kuriloff, Min Zeng

U.S. bond yields are topping a key measure of the dividends that large U.S. companies pay—a shift that has broad implications for investors who have viewed higher stock yields as underpinning an eight-year-long bull market.

At 2.50%, the yield on the 10-year U.S. Treasury note on Friday exceeded the 1.91% dividend yield on the S&P 500, according to FactSet. The dividend figure reflects annualized payouts by companies in the index as a proportion of their current share price.

Rising bond yields generally send a signal that the economy is healthy and that demand for goods and services is rising. But increases in long-term yields over time also stand to shift investor preferences that recently have been strongly skewed in favor of stock investments.

It is a change with real ramifications. Just a year ago, when U.S. bond yields hit record lows, many investors were buying bonds for asset appreciation and stocks for yield, an inversion of longstanding investing principles.

Many investors say ultralow bond yields have played a major role in the postcrisis rally, which this month took the Dow industrials above 21000 for the first time. The Dow closed Friday at 20914.62.

“Low Treasury yields are the foundation of current high valuation of financial assets,” said Zhiwei Ren, portfolio manager at Penn Mutual Asset Management Inc. A 3% yield on the 10-year Treasury note “will start to spook the stock market,” he said.

The bond yield-dividend yield comparison has recently been a crucial argument in favor of stocks. Comparing the yield on a company’s stock or a market index with the Treasury rate showed higher dividend yields made stocks a better bet, an easy shorthand indicating investors could receive higher returns even if share prices decline.

The calculus has been distorted in recent years by economic and policy changes that took effect after the financial crisis, with slow economic growth and bond buying from the Federal Reserve driving bond yields sharply lower.

As a result, the 10-year Treasury bond yield has spent much of the postcrisis period below the S&P dividend yield—something that as of 2008 hadn’t happened for roughly half a century.

Yet bond yields have been largely above dividend yields since the U.S. election. The increase in bond yields now appears to many analysts and investors to have staying power, the latest sign of the slow normalization of the financial world.

S&P dividend yields have generally stayed around 2%, which is below the historical average but looked almost generous at a time when bond yields were flirting with negative levels in many other major countries.

Gains in dividend-paying stocks last year helped propel the market’s rise off its February lows. Investors flooded into shares of utilities and consumer staples, as well as companies like Johnson & Johnson and Apple Inc.—demonstrating a willingness to sacrifice some safety for reliable income they weren’t getting from bonds.

Oracle Corp., Wal-Mart Stores Inc. and General Dynamics Corp. are among 110 companies that have raised their dividends this year by an average of roughly 10%, according to data from S&P Dow Jones Indices.

At the same time, yields on longer-term bonds remain low enough that many investors are skeptical the debt will retain its value over time against inflation—a view that bolsters demand for stocks.

© Paul J. Richards/Agence France-Presse/Getty Images

Many analysts remain uncertain about the broader significance of higher bond yields, which could point to either stronger growth or rising inflation—outcomes that would likely have vastly different ramifications for various asset classes.

If rising bond yields are “a signal of higher inflation in the future, it may be a bad sign for all financial assets,” said Aswath Damodaran, a professor at New York University’s Stern School of Business. “I am not sure that I’m ready to tag it yet.”

If growth slows, climbing bond yields may weigh on equities and leave them vulnerable to shocks, analysts at Goldman Sachs Group Inc. wrote last week while cutting their three-month outlook for stocks to neutral.

In 1994, when the 10-year Treasury yield surged by two percentage points driven by aggressive rate increases from the Fed, the S&P 500 fell 1.5%. Yet in 2013, when the 10-year yield jumped by more than one percentage point amid anxiety over reduced bond buying from the central bank, U.S. stocks soared.

“U.S. stocks are not cheap,” said Russ Koesterich, co-portfolio manager for BlackRock’s Global Allocation Fund, who is avoiding yield-sensitive sectors of the market such as utilities stocks, which are known as bond proxies for their relatively high dividends, and leaning toward shares that do better in times of economic growth.

Prices for utilities in the S&P 500 peaked last summer, though they helped lead the index’s gains last week after the Fed signaled a gradual pace to interest-rate increases.

Apple was the most-sold stock by TD Ameritrade clients in 2016, according to data from the retail brokerage, though the iPhone maker remained clients’ top holding.

Net inflows to dividend-heavy exchange-traded funds have slowed for three straight weeks through March 8, to their lowest level since the week ending Jan. 18, according to data from fund tracker EPFR Global.

While earnings have improved after several quarters of declines, they have been lifted by a rebound in energy prices, increased cost-cutting and inexpensive labor, while business investment has lagged, some analysts said. Productivity remains muted, and an aging population suggests limits to growth.

Companies in the S&P 500 traded last week at roughly 22 times their last 12 months of earnings, above their 10-year average of 16, according to FactSet.

David Kotok, chief investment officer at Cumberland Advisors, said he is holding 15% cash in client ETF accounts, concerned that stock valuations were already stretched before indexes climbed on hopes for policy outcomes that may never arrive. The impact of rising yields “is another arrow in the quiver of those who think the stock market is too richly priced,” he said.

Write to Aaron Kuriloff at aaron.kuriloff@wsj.com and Min Zeng at min.zeng@wsj.com

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