Like a magician who uses misdirection to distract the audience from what really matters, the possibility of a government shutdown—still to be determined as of press time—took investors’ attention away from the slow rise in Treasury yields.

That’s too bad, because the latter might ultimately matter more for the stock market than the former.

Not that you’d know anything serious happened last week simply by looking at the benchmark returns. The Dow Jones Industrial Average gained 268.53 points, or 1.04%, to 26,071.72—just another all-time high—while the Standard & Poor’s 500 index rose 0.9%, to a record 2810.30. And the Nasdaq Composite climbed 1%, to 7336.38, also an all-time high. The S&P 500 has now closed at a record level 10 times this month, just one short of the record of 11 set in January 1964—with eight trading days to go.

Do you know what else rose to a new high, though not a record one? The 10-year Treasury yield, which closed at 2.639% Friday, its highest since July 2014. The stock market didn’t mind—obviously—and there are many who believe that yields can just keep heading higher without dinging equities, as long as increases are driven by growth and inflation. Others contend that it’s the speed of the move that will determine whether stocks rise or fall, if the 10-year yield does indeed break higher. “The market doesn’t like quick moves,” says Quincy Krosby, chief market strategist at Prudential Financial. “That gives it the jitters.”

Not everyone is so sure. Jim Paulsen, Leuthold Group’s chief investment strategist, notes that bond yields have been trending lower for the past 38 years, and have remained within one standard deviation—a measure of the dispersion of readings from the average—for 72% of that time. Why is this important? The 10-year’s 2.64% yield is now above the current one-standard-deviation mark of around 2.44%, he says. That’s occurred just 12.6% of the time since 1980, but when it did, equity returns were markedly lower than when yields were in the range: The S&P 500 has advanced an average of 2.7% during the 12 months following such an instance, versus an average of more than 10% when yields remain contained within the bands. “The perception of normal rates has come down so much that it might not take a lot to hurt stocks a bit,” Paulsen says.

David Ader, chief macro strategist at Informa Financial Intelligence, takes it a step further: He wonders if you can be bearish on Treasuries—bond prices fall as yields rise—and still be bullish on stocks. He notes that the difference between the 10-year yield and the S&P 500’s dividend yield has widened to about 0.6 of a percentage point in favor of Treasuries. The wider that gap grows, the more enticing bonds will become to investors who still need yield. “My target is 2.85% to 3%,” Ader says. “If we reach that, the equity market will go the other way.”

(Source: Barrons Online)