Fundamentally: When Interest Rates Rise, Stocks Needn’t Fall

Here’s the reality: In May, rates actually rose quite sharply, as 10-year Treasury yields jumped to 2.16 percent from 1.63 percent. Yet the Dow Jones industrial average still soared more than 400 points, to end the month at 15,115.57.

The stock market’s road did become choppy as rates rose. The Dow lost more than 200 points on Friday, for example, but the overall trend remained upward. It just goes to show that while there is a connection between interest rates and the stock market, it isn’t a simple one. When rates rise, said Jeffrey N. Kleintop, chief market strategist at LPL Financial, “it is not the size of the move itself, but the absolute level of yields reached that matters to the stock market.”

Even with the recent uptick, the 10-year yields are only about half of what they were five years ago, during the global recession. And a climb in rates from such a low level may be a tail wind — not a headwind — for stocks, Mr. Kleintop said.

For starters, he said, “it reflects an improving outlook for economic growth and less risk of deflation.” Both are welcome developments to equity investors. Moreover, “it results in losses for bonds,” he said, which may prompt investors to sell those bonds and move money into stocks.

Indeed, over the past month, the average bond fund that invests in long-term government debt has lost more than 6.5 percent of its value, according to Morningstar, the investment research firm. The typical blue-chip stock fund, meanwhile, has gained about 4 percent.

But this is not to say that rising interest rates wouldn’t hurt the stock market at all.

For instance, if rates were to climb enough to threaten the rebound in housing, stocks might start to sing a different tune, market strategists say. But the average 30-year fixed-rate mortgage is still at a historically low 3.81 percent, even though that rate is up since the end of April.

Similarly, climbing rates would threaten stocks if they signaled rising inflation, so that the Federal Reserve might have to curtail its efforts to stimulate the economy. But the most recent reading of the Consumer Price Index showed that prices were up only around 1.1 percent over the past 12 months. That’s down from the 1.6 percent pace of inflation at the start of the year.

So how much would rates have to climb before investors became seriously worried about stocks?

If history is any guide, the threshold is around 6 percent.

Doug Ramsey, chief investment officer at the Leuthold Group, has looked at stock valuations and bond yields going back to 1878. He has found that while there is a relationship between the two, big trouble for the stock market appears to kick in only when 10-year Treasuries are yielding 6 percent or higher.

Theories abound as to why 6 percent seems the magic number. James W. Paulsen, chief investment strategist at Wells Capital Management, argues that 6 percent is important because it reflects the overall economy’s nominal long-term growth rate. “I can see why you’d get a negative reaction if the cost of capital for the market was above the inherent, sustainable growth rate of the economy,” he said.

Mr. Ramsey offers a slightly different explanation. He said that for rising bond yields to hurt the stock market, they would have to be viewed by investors as real competition to stocks. Perhaps at 6 percent, he said, bond yields are high enough that “they are truly thought of as potential replacements or substitutes for long-term stock returns.”

TO be sure, some market watchers say what really matters isn’t the current move in long-term market rates, but what happens with the short-term rate that the Fed controls.

Recently, Ben S. Bernanke, the Fed chairman, hinted that the central bank might soon begin to taper its purchases of Treasury bonds as part of its efforts to stimulate the economy. He did not offer any clues, however, as to when the federal funds rate, now 0.25 percent, might be lifted.

John Stoltzfus, chief market strategist at Oppenheimer & Company, noted that whenever the Fed does raise short-term rates, “it could create a jostle in the stock market.” But Mr. Stoltzfus warned investors not to assume that Fed increases would immediately pull the plug on the bull market.

He notes that the last time the Fed started raising rates was in June 2004, when the funds rate was at 1 percent. The central bank proceeded to lift rates 17 times through the end of June 2006. During that stretch, the Standard & Poor’s 500-stock index rose 11.3 percent, while the Russell 2000 index of small-company stocks gained 22.5 percent. In the 12 months that followed — while the Fed held rates steady — stocks continued to post double-digit gains.

“What really counts here for investors is, are rising rates crimping the affordability of credit?” Mr. Stoltzfus said. With two-year Treasury notes yielding just 0.29 percent, he said, “I’d argue that we’re far from that point.”

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Fundamentally: The Stock-and-Bond Mix Is Tough to Rebalance

PORTFOLIO rebalancing — periodically resetting a mix of stocks and bonds by taking profits from outperforming investments and buying cheaper, underperforming ones — has always posed a challenge.

Rebalance too often and you’ll sell profitable investments too soon and miss out on big gains. But wait too long and the market will alter your strategy and risk profile in ways you may never have intended.

If the stock market has been rising, for example, you may be holding way more stocks than you’re comfortable with. If the bond market has been climbing, you may have gone too far in the fixed-income direction, even though you want to own more stocks.

In some ways, today’s market has made rebalancing even trickier. Since the start of 2012, a basic stock fund that tracks the Standard & Poor’s 500 index has soared 29 percent, while a typical bond portfolio has returned less than 5 percent. Traditional rebalancing would dictate that investors sell some of their surging equities, thus keeping their portfolios from becoming too stock-heavy and risky. This would be a particularly important safeguard for investors if the bull market is nearing an end.

That money, then, would be used to bolster allocations to fixed-income investments. Yet market analysts note that with 10-year Treasury securities now yielding just 1.7 percent, bonds are about as richly priced as they’ve been in decades.

So should investors use discipline and stick with their plans, even if that means buying bonds they think are expensive? Or should they adhere to the lessons of the last decade by refusing to buy investments they consider overpriced? Just as there’s no right answer about how often to rebalance — studies are inconclusive about whether it’s better to do this quarterly or annually — financial planners and market analysts say that no single answer suits all investors.

Instead, there are several basic options.

The first strategy is to stay the course and rebalance if your portfolio is out of whack — just tweak the types of bonds you buy. Mark R. Freeman, chief investment officer at the Westwood Holdings Group, notes that the primary rationale for rebalancing is to manage the overall risk of a portfolio. Just because investors are wary of bonds is no reason to let their portfolios become overexposed to equities, which are likely to lose far more value than bonds in a market correction.

Harold R. Evensky, president of Evensky & Katz Wealth Management, agrees. “The idea is to maintain your investment policies, but to adjust to market conditions,” he said. “For instance, you could always shorten your duration,” he noted, meaning that you could rebalance into bond funds that invest specifically in short-term securities, which are less likely to lose value should interest rates rise and bond prices fall.

Judith B. Ward, a financial planner at T. Rowe Price, said picking and choosing where to redeploy that rebalanced money might be fine for experienced investors who closely tracked the markets and their portfolios. For less engaged investors, though, she said there was a simpler approach: rebalance now if it seems time to do so, but just make sure that the money going into fixed income is extremely well diversified across all major areas of the bond market.

“If you diversify, and have exposure to international and domestic bonds, government and corporate securities, and bonds of different durations,” Ms. Ward said, “your bond portfolio is probably not going to suffer as much as you might think in a worst-case scenario.”

But there’s a catch here, too.

Many people, particularly those who invest primarily in their 401(k) retirement plans, are likely to turn to a so-called total bond market index fund to diversify their fixed-income holdings.

“There is a perception out that there that if I own one of these index funds, I own the total bond market,” said Kathy A. Jones, a fixed-income strategist with the Schwab Center for Financial Research.

That’s not the case. Many bond funds mirror the Barclays U.S. Aggregate Bond index, which includes very little non-United States debt as well as relatively few high-yield or junk bonds. Around 75 percent of the index tracks government securities or other types of government-backed bonds. Less than 25 percent is in corporate bonds.

“At the end of the day,” Ms. Jones said, “these funds may own a lot of different bonds, but you don’t get much issuer diversification, and you’re getting that at very low yields.”

Because of this, says John C. Bogle, founder of the Vanguard Group, total bond indexes “are deeply flawed — and that’s coming from an indexer.”  He adds that individual investors should keep only about one-third of their bond stake in Treasuries and government debt, reflecting the market’s mix based on private investors such as pension and mutual funds.  

Investors might consider keeping half their money in a total bond market fund, he said, while shifting the other half to an intermediate corporate bond fund. By doing so, investors would end up with an overall strategy that’s about two-thirds in corporate debt and one-third in government securities.

As far as rebalancing goes, Mr. Bogle notes that there is another option: hold off. “Rebalancing is something I don’t think anybody should follow slavishly,” he said.

To be sure, annual rebalancing can keep a portfolio from veering drastically off course over time. For instance, heading into the 2008 market plunge, more than one out of five 401(k) investors aged 56 to 65 held more than 90 percent of their retirement accounts in stocks. Presumably, many got to that risky allocation by failing to rebalance.

But Mr. Bogle says that over very long periods, rebalancing doesn’t necessarily pay off, because investors are constantly selling out of higher-performing assets.

A compromise is to set basic thresholds. Rather than automatically rebalancing each year, investors can just establish a range — say, of five percentage points or more around their allocation target. So you don’t have to rebalance back to, say, 60 percent stocks until that weighting hits 65 percent or even higher.

At the least, he said, “Don’t say, ‘Oh my God,’ I’m up to 60.4 percent stocks and I want to stay at 60.’ ”

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Fundamentally: Europe’s Markets, No Longer in Lock Step

Money managers point to signs like these: Investors barely flinched during the banking crisis last month in Cyprus, an indication that the Continent may be moving past its manic phase. The Vstoxx index, a measure of stock market volatility in the euro zone, is about half of what it was in the fall of 2011, when the region’s debt crisis spread to Greece and Italy. And Europe has actually been the best-performing major overseas market since the start of 2012, with equities surging nearly 19 percent.

“The markets get that it’s not 2011 anymore,” said Edward A. Gray, a co-manager of the Delaware International Value Equity fund.

But impressive as that change has been, the hard part may be coming now.

That’s because, until recently, the European market has followed a fairly simple, predictable pattern. When investors sensed that the fiscal crisis there was worsening, as in the late summer of 2011, European stocks sold off in lock step. Conversely, investors raced back into the region’s equities anytime there was better-than-expected economic news — like that of the second Greek bailout, in the first quarter of 2012.

Now that European stocks appear to be past these extreme swings, investors are “much more fundamentally focused and discriminating,” said Harry W. Hartford, president of Causeway Capital Management. That means European stocks “are not a homogeneous entity anymore,” he added.

Consider the performance of European stocks in the first quarter. While stock funds that invest broadly in the region returned 2.6 percent, on average, the stock markets of individual countries were all over the map. Greece, for instance, finished the quarter up more than 14 percent and Switzerland gained more than 10 percent. Germany, meanwhile, was flat, while Spain sank 6 percent and Italy fell nearly 10 percent.

Future success in Europe will require investors to distinguish not only among markets, but among sectors and individual stocks as well, money managers say. But it is becoming harder to find decent values among European stocks, said Kimball Brooker Jr., a co-manager of the First Eagle Overseas fund.

Broadly speaking, European equities still trade at lower valuations than domestic or Japanese shares. Yet the broad market’s price-to-earnings ratios don’t necessarily paint an accurate picture of the investment landscape, Mr. Brooker said.

For instance, a few years ago, it was fairly easy to find shares of high-quality multinational companies in the region that were trading at discounted prices relative to their American counterparts, simply because they were based in Europe. Today, those types of industry-leading companies — those with pristine balance sheets that generate a large portion of their sales in faster-growing areas like emerging markets — are becoming expensive.

These are companies like L’Oréal, the beauty products giant based outside Paris, and Diageo, the spirits maker based in London, said Charles de Vaulx, chief investment officer at International Value Advisers. Both stocks are trading at P/E ratios well above 20.

“These stocks are very pricey, but deservedly so,” he said, owing to their strong finances and geographic reach. But that leaves fewer apparent opportunities for value-minded investors looking to put new money to work.

“To find generally cheap stocks in Europe, you have to look for cyclical businesses that require you to believe that we’re on the verge of a major economic recovery,” Mr. de Vaulx said. “Unfortunately, we worry that European economies are decelerating.”

THIS explains why only about 57 percent of the assets in the IVA Worldwide fund, for which Mr. de Vaulx is a co-manager, are currently in equities. That’s down from 71 percent a year ago. Furthermore, only about 145 percent of the total portfolio is in European equities, with double that stake held in the United States.

European stocks are facing increasing competition for global investment dollars now that Japan’s stock market is finally rebounding, said Mark D. Luschini, chief investment strategist at Janney Montgomery Scott.

Japanese stock funds, in fact, soared 15 percent in the first quarter, more than their gains in all of 2012. And over the past six months, the MSCI Japan stock index has climbed by nearly 42 percent.

For European equities to continue to rally in the face of such stiff competition, from both Japan and the United States, “it’s going to require some kind of positive catalyst,” Mr. Luschini said.

In the short run, he said, he does not know whether any economic indicators will provide such a lift.

But over a five-year horizon, he says he thinks European markets could still turn out to be among the more attractive foreign destinations, especially if European companies can keep increasing their profitability while the economy slowly heals.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.