Wall St Week Ahead - Fed change unlikely to blunt equities' appeal over bonds

By Akane Otani

NEW YORK (Reuters) - The recent wobbly stretch in both stocks and bonds may persist for the short term if the U.S. Federal Reserve next week lives up to expectations and signals the days of near-zero interest rates are numbered, but it is unlikely to tip valuation scales in favor of bonds any time soon.

Anxiety over the two-day Fed policy meeting, centered on expectations the central bank will likely drop its pledge to keep interest rates low for a "considerable time," was a primary driver behind stocks snapping a five-week winning streak this week and bonds absorbing their steepest losses in at least two months.

Top economists at several firms say they see at least even odds the Fed will nix the phrase from its forward guidance, which some traders may interpret as meaning that rate hikes could come as early as next March.

"If investors feel the Fed is becoming more hawkish, that's actually a negative for all asset classes with the exception of the dollar," said Chris Gaffney, senior market strategist at EverBank Wealth Management in St. Louis, Missouri.

Still, few expect such a move would translate immediately into a long-term change in investors' bullish view of stocks, especially relative to bonds.

To be sure, signs of sooner-than-expected interest rate hikes could chip away at investors' optimistic view of stocks, which scaled to new heights in no small part thanks to the Fed's quantitative easing program and decision to hold interest rates near zero percent for nearly six years now.

But with bond yields still extraordinarily low by historic standards, and unlikely to rise drastically, many investors see equities as one of their few prospects for long-term growth.

Market watchers say it is unlikely the prospect of interest rate hikes will significantly dampen investors' taste for stocks or prompt a large-scale reallocation of funds into bonds.

"There's no doubt that there will be some volatility in the short term, but at some point equilibrium will come into the market," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.

While measures such as the forward price-to-earnings ratio on the S&P 500 suggest stocks are their priciest in nearly a decade, other measures of relative valuation to bonds remain skewed in favor of equities.

The S&P's so-called earnings yield, the inverse of the price/earnings ratio and a common yard stick for comparing equity valuations against bonds, is roughly 6.3 percent. That is 3.7 percentage points higher than the 10-year Treasury yield, currently 2.6 percent, whereas the long-term spread between the two is about 1.5 percentage points.

When measured against corporate junk bonds, the bond market's biggest competitor to stocks for asset flow, valuation math is tilted even more heavily in favor of equities. The average yield to maturity on junk bonds is just 6.3 percent, according to Bank of America/Merrill Lynch fixed income index data, but the long-term average junk yield is 9.4 percent.

Moreover, U.S. corporate earnings are projected to resume double-digit growth in coming quarters, according to Thomson Reuters data, which would keep a lid on P/E multiple expansion, perhaps even compress it if profit growth outpaces stock price increases.

That suggests stocks remain the better bet for returns, at least until interest rates rise significantly enough to return relative valuation measures between the two to historic norms.

In the current market environment, "There's not really a better alternative to stocks right now," says Gaffney.

(Reporting by Akane Otani; Editing by Leslie Adler)