S&P 500 P/E Reversal Seen as Yield Gap Narrows: Chart of the Day

A catalyst for the Standard & Poor’s 500 Index to rise above 2,000 yesterday may reverse itself if Treasury yields are any indicator, according to Gina Martin Adams, a Wells Fargo & Co. equity strategist.

As the CHART OF THE DAY shows, the gap between yields on two-year and 10-year Treasury notes -- also known as the yield curve -- narrowed this year as the price-earnings ratio on the S&P 500 rose.

Ten-year notes yielded 188 basis points more than the shorter-maturity debt yesterday, according to data compiled by Bloomberg. The differential was 264 basis points when the year began. The S&P 500 P/E climbed to 18 from 17.3 during the same period, and reached a four-year high in June. Each basis point amounts to 0.01 percentage point.

“Index P/E is likely to fall” as the spread narrows further, Martin Adams wrote yesterday in a report. She cited data showing the ratio contracted in seven out of eight periods when the curve flattened since 1975. The exception occurred in 1998-2000, during a bull market for stocks.

As earnings become less valuable to investors, stock performance will become more closely linked to profit growth, the New York-based strategist wrote. She added that shares of energy, industrial and technology companies may perform best, based on track records when yield gaps narrowed previously.

Martin Adams expects the S&P 500 to end the year at 1,850, down 7.4 percent from yesterday’s close. She and Deutsche Bank AG’s David Bianco are tied for the lowest prediction among 20 strategists in a Bloomberg survey.

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