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Olivo Barbieri

Ask a bullish investor why stocks will keep rallying despite having more than doubled over the past four years, and the response you'll often hear starts with, "Because interest rates ..." As in: Because interest rates are so low, stocks are cheap relative to bonds and therefore have room to run.

Now ask a bear why this rally is nearing an end, and the response you'll get also begins: "Because interest rates ..." In this case: Because rates have been kept so low for so long by the Federal Reserve, they're bound to climb once the Fed starts to signal that it's ready to end its unprecedented stimulus efforts. And rising bond rates stamp out stock rallies.

Who's right? According to new research, neither.

That's the conclusion that Doug Ramsey, chief investment officer for the Leuthold Group, drew after studying the relationship between yields on 10-year Treasury securities and stock valuations going back to 1878.

He discovered that bond yields really affect the prices that investors are willing to pay for stocks only when 10-year Treasuries are yielding about 6% or higher. Below that level, "the correlation between the two has been essentially zero," Ramsey said.

James Paulsen, chief investment strategist for Wells Capital Management, conducted a separate analysis that compared 10-year Treasury yields with price/earnings ratios on the S&P 500 index since 1950. His findings were similar to Ramsey's: Bond yields begin to bring down P/E ratios only when 10-year Treasury bonds are paying 6% or more.

What's up with 6%?

Ramsey argues that for bond rates to have sway on stocks, bonds have to be regarded as a legitimate alternative to equities. It's at 6% that fixed-income yields "appear to hit that threshold where they are truly thought of as a potential substitute for long-term stock returns," he says.

Whether or not you buy that argument, his and Paulsen's research show that bulls really can't base their case for stocks on today's 1.7% bond yield.

There's also a lesson here, though, for bears. Just because fixed-income yields are likely to rise as the economy improves and the Fed stops buying bonds to keep rates low doesn't mean stock investors are about to be mauled.

Indeed, between mid-2004 and mid-2006, the Fed hiked short-term rates 17 times, which helped drive 10-year bond yields from around 4% to 5.2%. Yet during that two-year stretch, the S&P 500 returned 15%. That's hardly a raging bull by historical standards, but it's better than what the bears are selling.

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