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Interest rates have ticked higher. The yield on the benchmark 10-year Treasury note moved above the psychologically important 5% level to close at 5.1% on June 7.
And stock prices have moved lower. The Dow Jones Industrial Average ($INDU) followed up declines June 5 and 6 with an almost 200-point drop June 7. Over the three days, the Dow shed 3% of its value.
What's next? I don't think the current dip yells a loud "sell" on your portfolio. After recovering from what is likely to be a modest correction, a broad market index like the S&P 500 Index ($INX) is likely to tack on an additional 3 to 5 percentage points to what was, before the recent drop, a 9% gain for the year. Not a bad year, all in all.
But some sectors will do worse than the stock market as a whole, the recent dip reminds us. And some sectors will do better. If your portfolio goes light on financials, utilities, real estate and consumer goods, I think you'll avoid performance-lowering pockets of the market. The right sectors to overweight include energy (still) and capital goods. I'll end this column with five specific stocks to add to your portfolio in the coming weeks to improve your chances of beating the general market for the second half of 2007.
Nothing severely off-kilter
By itself, a climb to a yield above 5% on the 10-year Treasury isn't enough to derail this stock market rally. Money that was very cheap is now just a tiny bit less cheap. And if recent indicators showing the economy will recover to post growth near 3% in the second half of the year are correct, company earnings growth should be fast enough to support what are, at this point, historically reasonable price-to-earnings ratios, especially considering the current low interest rates.The S&P 500 traded at just 17.9 times operating earnings for the four quarters that ended March 31. That's about average for the S&P 500, so on raw P/E ratios alone, stocks are neither cheap nor expensive.
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Is stagflation on the way?After the sell-off in the market during the week of June 4-8, the U.S. economy could take several turns for the remainder of 2007. MSN Money’s Jim Jubak says a 12-15% return on stocks is most likely, but a slow economy and rising interest rates could mean trouble.
But raw P/Es aren't a particularly accurate indicator of stock market values when interest rates are at an extreme, either very high or very low. One tool for turning P/E ratios into a measure that takes account of interest rates is called the Federal Reserve valuation model. This model argues that the stock market is fairly valued when the yield on the 10-year Treasury matches the earnings yield on stocks. As of June 7, with the S&P 500 at 1,471, it says stocks were undervalued by about 17%. At fair value, with the yield at 5.1%, the S&P 500 would trade at 1,740. (The earnings yield is simply the P/E ratio turned upside down. Instead of dividing price by earnings per share, you divide earnings per share by price to find out how many dollars in earnings you get for each dollar you pay.)
The Fed model also shows you exactly how sensitive stocks are to interest rates. An increase in the 10-year yield to 5.4% would bring the stock market's fair value down to 1,660. A climb in yield to 5.6% would take fair value down to 1,600. And so on.
Continued: Higher rates anticipated
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