Stocks: Beyond the panic

NEW YORK (CNNMoney.com) -- First it was a selloff in Chinese markets. Then it was subprime. And now it's the runup in Treasury bond yields that's become Wall Street's latest bogeyman.

Funny how these issues seem to send stocks tumbling right around the time that the major gauges have just made new highs.

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That was the case last week, when worries about an overheating global economy sent the benchmark 10-year Treasury yield - which impacts mortgage rates and other consumer loans - to a 5-year high above 5.3 percent. Stocks tanked in response, with the major gauges sinking some 3 percent over three sessions on worries about the impact of rising rates.

But the slump also came right after the Dow industrials (Charts), the S&P 500 (Charts) and the Russell 2000 (Charts) small-cap index all closed at record highs. The tech-fueled Nasdaq composite (Charts) had hit a 6-year high. All that during the seasonally weakest part of the year, the May through October period.

That's not to say that rising rates won't have a broad and possibly negative impact on the economy and a wide swath of investments, including real estate as well as stocks. (Click here for details).

But the impact on the U.S. stock market - at least in the near term - is shaping up to be milder than some investors had feared just a week ago, thanks to positives like upbeat earnings and the ongoing flow of funds into the market from buyout deals and stock buyback plans.

The stock market is supposed to react quickly to big events, like the rise in bond yields. But lately, the knee-jerk reactions haven't changed the market's direction beyond the short term. That could certainly be the case again.

"The excuse for selling was as much that we were overbought as it was interest rates and inflation," said Art Hogan, chief market analyst at Jefferies & Co. "More than anything else, the market needed to blow off steam, and it was similar to what happened in February."

On Feb. 20th, the Dow ended at a record high, and the S&P 500 and Nasdaq composite ended at 6-year highs as investors continued to welcome solid corporate earnings, corporate stock buybacks and a plethora of deal news.

But then came rumblings that global growth was going to slow. Former Federal Reserve Chairman Alan Greenspan said the U.S. economy was at risk of slipping into recession by the end of the year. And stocks started to fall.

A week later, on Feb. 27th, a 9 percent tumble in stocks in Shanghai sparked a global selloff on worries that economic growth worldwide was going to tank. Adding to the jitters: the idea that the U.S. economy was going to suffer doubly from a subprime mortgage fallout as well as slowing world growth.

The Dow plunged 416 points - its biggest point loss in 5-1/2 years - on worries that the bull market was over.

Stocks at home and abroad did weaken on and off over the next two weeks, but then the concerns were tempered, investors refocused on the positives and stocks began climbing, setting the stage for a powerful three-month rally that took the market to record highs - until the recent rate rise sparked another pullback.

So here's a look at some of the worries that caused the recent selloff and the silver linings that could limit their impact on U.S. stocks later in the year.

Worry: Yields are rising, energy prices are still high and the Fed will boost its key short-term rate later this year in a bid to ward off inflation, hurting stocks.

But: While Treasury yields may rise further, recent inflation reports, including Friday's consumer price numbers, point to moderate pricing pressure, and indicate the rise in energy prices does not seem to be driving up core inflation. Despite the strong labor market, wage growth has been modest, and wages are the biggest driver of inflation. So many Fed watchers think the central bank is on hold for the rest of the year.

"The runup in yields was more of a repricing on bets that the Fed isn't going to ease, indicative of a stronger growth environment," said Joshua Shapiro, chief economist at Maria Fiorini Ramirez Inc. "We think the runup is overdone and that the Fed is not going to raise rates."

Worry: Yields spiked because the economy is overheating, another possible spark for higher inflation.

But: If rates are rising because the economy is strong, that's a positive for stocks, considering that first-quarter economic growth at a 0.6 percent rate was the slowest in 5 years. A stronger economy, paired with moderate pricing pressure, would help reaccelerate corporate profit growth, which would then make stock prices more attractive due to the stronger growth, said John Davidson, president and CEO at PartnerRe Asset Management.

Worry: The rise in rates marks an end to an era of cheap capital, which is going to cut off the private equity boom and pull the rug out of stock buybacks, which have helped fuel the stock rally.

But: Higher rates will have an impact on the buyout boom, but are unlikely to stop the train just yet, or the stock rally. (Full Story)

"At some point the liquidity dries up, a deal goes bad, private equity become sellers instead of buyers, but for now it can keep going," said James Awad, president at Awad Asset Management.

Worry: Yields are going to keep rising aggressively, making bonds more appealing to nervous investors than stocks.

But: No less than PIMCO bond guru Bill Gross has said Treasurys are in a bear market, suggesting rates are set to rise further. But since topping out at 5.32 percent, the yield on the 10-year note has backed off and stood Friday at about 5.19 percent. Market watchers say any subsequent rise in yields won't be at the frenzied pace of last week's runup.

Additionally, while higher bond yields make Treasurys more attractive, they don't really become a competitive threat to stocks until they exceed 6 percent, according to J. Bryant Evans, portfolio manager at Cozad Asset Management.

"At that points, some investors who look for high yields in equities are going to sell stocks to buy bonds," Evans said.

Worry: At 4-1/2 years old, the bull is getting feeble and the rise in bond yields could be the straw that breaks the animal's back.

But: The new challenges are likely to make things more choppy on Wall Street, but rather than expecting a major selloff - a drop of 5 to 10 percent or so -investors would be better off looking for some sector rotation.

"I think we'll start to see performance rotation and that will keep us in a trading range for a while," said Lincoln Anderson, chief economist and chief investment officer at LPL Financial Services.

Traditional defensive stocks that tend to do well when rates are rising are bound to benefit, such as healthcare, food and beverage stocks, aerospace and defense and others, while higher energy and commodity prices should benefit those stocks.