Party over in world stocks? Not yet for investors

Rising bond yields globally are rattling world stock markets, sending them to their worst drop since mid-March, but the big, bad equity correction might have to wait.

“You have to have these pullbacks because nothing goes straight up,” said Paul Hickey, co-founder of Bespoke Investment Group. The MSCI All-Country World Index on Wednesday finished its worst two-day drop since mid-March. That came on the heels of gains between March and the end of May of over 10%, and it is still up around 8.8% year-to-date.

Similarly, the Standard & Poor’s 500 also suffered its biggest two-day drop since mid-March this week, following gains of 7.72% in April and May. That was the index’s best two-month run in nearly four years. Small wonder investors are hitting the beach, even if briefly, for an early summer break.

The selling pressure in stocks has accelerated because of the rise in global yields, which has been fuelled by fears there will be no interest rate cuts this year after all, and may even be further interest-rate rises by the Federal Reserve and foreign central banks.

In its eighth interest rate rise since late 2005, the European Central Bank (ECB) lifted rates to a six-year high on Wednesday as it attempted to prevent economic growth from driving up inflation in the euro zone. Later in the session, New Zealand’s central bank raised interest rates by a quarter of percentage point to 8%, saying it was worried robust consumer demand would further fuel inflation.

This week, Merrill Lynch and Goldman Sachs Group both abandoned their forecast for any interest rate cuts this year by the Federal Reserve. The yield on the benchmark 10-year treasury note, which closed at 4.970% on Wednesday, has seen its yield climb 9 basis points from one week ago.

Yet investors say rising global yields aren’t enough to derail the bull run in stocks. In fact, rise in government bond yields around the globe are a reflection of strengthening domestic demand and capital spending growth.

“Central banks also are keen to normalise interest rates, following years when interest rates and yields were abnormally low,” added Warren Smith, managing editor of BCA Research in Montreal, Canada. There is a downside to improving economic growth prospects though. Smith said higher US bond yields risk dragging out the US housing slump and prolonging the economic slowdown. Michael Jones, chief executive office at Clover Capital Management in Rochester, New York, said US interest rate expectations have undergone an about-face and changed the outlook for the stock market.

“I think that is likely to be at least an excuse for a correction of this major positive upmove that we’ve had the last couple of months,” Jones said.

But Jones said a downturn should not be a cause for trepidation.

“We don’t live in fear of this market going down or this cycle coming to an end, but we recognise that it’s going to happen some day,” Jones said.

That day is unlikely to emerge soon. Even Chinese equities, having corrected by a larger amount over the past week than they did during the February-March correction, did little to spook world stock markets.

In fact, global markets are “totally ignoring” China this time, noted Larry Jeddeloh, chief financial officer of the TIS Group, which produces the Market Intelligence Report. The Shanghai Composite Index which had tumbled as much as 7.25% in early Wednesday, finished 2.63% higher at 3,767.101 points. The index had plummeted 21% since last Wednesday amid concerns about a stock-trading tax increase which was intended to cool the bull run. It is as if other markets regard the decline in Chinese stocks as healthy, Jeddeloh said. “They want it to happen, so when the market gets what it wants, up it goes,” he added. All told, strategists say the bull market in stocks still has some life because of the excess cash corporate America is putting to work in the form of share buybacks and cash-funded mergers and acquisitions.

“Liquidity conditions now are the exact opposite of what they were in 2000,” when corporations sold large amounts of shares in secondary offerings or IPOs, said Charles Biderman, chief executive officer at TrimTabs Investment Research.

While corporate America was a net seller of $101 billion in equities in 2000, it has been a net buyer of $396 billion of its own shares so far in 2007, shrinking the net float of the stock market available for investors.

Mutual fund investors are also acting differently. “While they heavily favoured US equity funds in 2000, US equity funds have been the least popular major fund category so far this year,” Biderman summed up.