WASHINGTON -- In the ugly war being waged on Wall Street between stocks and bonds, bonds are winning.

Analysts are now convinced that although most of the carnage in the bond market is over, rates are still likely to go higher. Meanwhile, even though companies are turning in glittering third-quarter earnings reports, the prospect of high interest rates and slower earnings growth has kept the stock market in a funk.

Historically, investors get a better return over the long run by buying stocks. But when interest rates start going up, bonds provide stiffer competition for stocks, and that is what is happening now.

Jeffrey Applegate, chief market strategist for CS First Boston, says he does not expect to see any relief for stocks for at least several months.

To analyze the stock market, Applegate looks at a common tool of analysts called the earnings yield on the S&P 500 index, which is calculated by dividing the earnings of all stocks on the index by their price. It is the inverse of the popular price-earnings ratio for stocks.

Currently, Applegate estimates the earnings yield on the S&P 500 index to be around 6.8%. By comparison, risk-free Treasury bills carry a rate of about 6%.

Moreover, many analysts expect short-term rates to go higher through at least the first three months of next year as the Federal Reserve tightens credit. Many are calling for T-bill rates in the range of 6.25% to 6.50%, which would be even more attractive compared with returns on stocks.

Another way of looking at stocks is to measure the dividend yield, or dividends as share of price, of the S&P 500 index. The current yield is around 2.87%, and that, too, is not likely to grow as rapidly as money-market rates over the next few months, says Applegate.

Robert Robbins, chief market strategist for the Robinson-Humphrey Co. in Atlanta, says he has dropped his guarded optimism about stocks and is now mildly bearish. "Interest rates keep on going up, and the technicals of the stock market keep deteriorating," he says.

Prices of the Treasury's 30-year bond have taken a beating this year and are now down about 25%, producing a yield of 8%. Robbins says stocks still have not undergone a 10% correction, which is the common measure of a bear market, although they came close with a drop of 9.7% early this year.

In a typical business cycle, bonds bottom out before stocks, Robbins says. But he figures that with a strong economy that has eaten up slack resources and labor, businesses will soon be paying more to produce goods and services. That will hurt the bottom line and shave earnings.

Interest rates have now gotten to the point where a bear market in stocks could be triggered by one big event that significantly worsens the inflation outlook -- and therefore the outlook for interest rates -- analysts at Robinson-Humphrey say.

Robbins says he likes municipal bonds, which can offer a tax-exempt yield of 6.5%, or the equivalent of 10.8% for wealthy investors in the top federal income tax bracket. The comparable return could be even higher for investors able to claim the added state tax exemption on bonds issued in their own state.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.