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When Will Rising Rates Sting Stocks?

Investors can't help but wonder at what level rising interest rates will give the stock market a reason to pause.

Some traders have pointed to a yield level right about where the 10-year has been this week: just above 3.5 percent. But a number of strategists are looking for a higher level before stocks start to get burned.

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"If you start pushing up north of 4 percent, stocks will pay attention," said Jordan Kotick, global head of technical strategy at Barclay's Capital. Kotick said 4 percent has proven to be a barrier, including the last time the 10-year reached it in April.

"I think the magnitude and trajectory does raise some concerns," said Jeffrey Kleintop, chief market strategist at LPL Financial.

"I think if we get much above 4 percent, I think stocks would have to pause and consider the economic ramifications of what that might be, and whether the Fed would have to take any additional action to keep rates down, and what that might mean."

But Jack Ablin, chief investment officer at Harris Private Bank, says there's no special level that will trigger a flight from stocks.

"I look at valuation differential between stocks and bonds. It's as gaping a difference as I've ever seen. Historically, I like to look at earnings yield on the S&P 500, which is 7.2, and I match it up against the 10-year BBB bonds, which are about 4.9 percent. Historically, those are roughly the same," he said, noting the current large disparity.

"My conclusion is stocks are probably fairly priced. Bonds are overpriced, yields too low... In theory, rates should be able to move higher without impacting valuations in stocks one iota. We're calling for roughly a 100 basis-point rise in rates on top of this," he said.

Ablin said that move would not necessarily derail stocks. "There's still an adequate cushion in my view that rates can move higher without upsetting the apple cart. I just don't know where the magic line is," he said.

Ablin issued his outlook for 2011 on Wednesday. "Stocks are reasonably priced, so I think we could eke out modest gains. My guess for 2011 is 8 percent is going to be the best returns we're going to see," he said.

Stocks Technically Sound

Stocks have side-stepped the rise in rates so far.

"The stock market seems pretty good. We felt some money was coming out of the bond market into the higher-yielding names three to four months ago..that was what we saw in MLPs (master limited partnership), utilities, telecoms like Verizon and AT&T ," said Paul LaRosa, technical analyst at Maxim Group.

"That to me was a sort of warning for the bond market," he said.

LaRosa said the complexion of the stock market is different than it was earlier in the year.

"The market should be concerned about the trajectory and about how fast we're moving in that direction, but not the level." -LPL Financial, Jeffrey Kleintop

"77 percent of the charts on the NYSE are in good technical health. That's pretty good. I'm seeing many more longs than shorts. The difference between now and earlier in the year, when we were bearish, is then many charts were topping out, like in energy, and that was pre-BP disaster; and in financials," he said.

"Now you look at financials in particular, you look at the XLF (financial ETF), and you're seeing people coming into it," he said. Traders have said the promise of higher dividends are the draw for financial names.

But LaRosa too agrees that 4 percent is an area to watch, since the stock market has struggled at that level when he charts it against the 10-year yield, going back to 1994.

Driving Yields Higher

Traders have debated the reason for the back-up in yields, and many see a steady stream of better economic news as a driver. Adding to that is the tax package approved by the Senate Wednesday that would extend Bush-era tax cuts for two years. The bill is expected to be approved by the House.

Analysts have pointed to the legislation as a catalyst for bond market selling, since the compromise was first discussed by President Obama last week. The bill includes a one-year break on Social Security taxes for individual taxpayers. Based on the package, economists raised their 2011 growth forecasts, which has been so far bullish for stocks and negative for bond prices. Some traders also say the package has prompted bond market selling for another reason: it will add to the ballooning federal budget deficit.

Rates have been moving higher since hitting a low in October, but the last several sessions have been particularly volatile. Rates shot even higher after the Fed Tuesday reaffirmed its intention to carry out its quantitative easing program. The Fed launched the program to buy a total $600 billion in Treasury securities in November, and since then rates have risen. In theory, quantitative easing was expected to have driven rates lower.

Mortgage rates have climbed along with Treasury yields, and the rate for a 30-year mortgage was at 5.19 percent Thursday. On Thursday morning, the 10-year note was yielding 3.55 percent.

"The market should be concerned about the trajectory and about how fast we're moving in that direction, but not the level. In the first quarter of this year, we averaged around 3.7, 3.8 on the 10-year and stocks were around this level, so these levels on rates certainly do not suggest stocks shouldn't be here, that they should be moving lower," Kleintop said.

"We're just getting back to a reaccelerating economic environment like we saw in the first quarter of this year, as we come out of the summer soft spot, you'd expect rates to rise and stocks to move along with it," he said.

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