Stocks are not bonds, so they shouldn’t be compared on an apples-to-apples basis. But that hasn’t stopped Wall Street strategists from promoting the idea that somehow, low interest rates will forever support the value of the stock market.

This idea shouldn’t be the reason why you hold stocks. You should hold a stock because you judge that its current market price greatly underestimates the underlying company’s cash-generating power -- the amount of cash that can be delivered to shareholders throughout its entire future life. Current interest rates are only one small factor in this judgment process.

The level of interest rates may flash useful “buy” or “sell” signals at market extremes, but it fails as a reliable indicator for long-term stock market returns. Nevertheless, this idea is mutating into a popular fantasy. This fantasy has convinced many investors that a stock is cheap if its “earnings yield” exceeds Treasury bond yields. An earnings yield is simply the inverse of a price-to-earnings ratio; a P/E of 20 equates to an earnings yield of 5%.

Using earnings yields to justify stock values ignores the simplest definition of earnings: revenues minus total costs. Dozens of factors determine earnings, and they fluctuate wildly throughout economic cycles. Bond coupon payments are fixed streams of cash that will be delivered to shareholders over, say, the next 20 years. Why are the two being confused?

A popular title of the earnings yield argument is called the “Fed Model.” This model says that stocks are a good buy when earnings yields exceed Treasury note yields. But it ignores market history prior to the epic 1982-2000 bull market. Using rigorous statistical analysis, John Hussman, portfolio manager of the Hussman Funds, proves that the Fed Model is not a reliable market indicator.

In “How Much Do Interest Rates Affect the Fair Value of Stocks?” Hussman writes:

“The Fed Model looks at the decline in earnings yields since 1980, and loads the entire explanation on the decline in interest rates. What actually happened is that you had a second factor -- the move from extreme undervaluation (abnormally high earnings yields) to extreme overvaluation (abnormally low earnings yields). The true ‘fair value’ relationship between earnings yields and interest rates is nothing close to 1-for-1.”

While the level of interest rates isn’t a reliable indicator, the long-term direction of interest rates certainly is. Falling interest rates tend to excite the stock market and rising rates tend to depress it. So if the recent spike in long-term Treasury yields continues, stock investors should start looking for the nearest exit.

This weekend’s issue of Barron’s featured an interview with Steve Leuthold, chief investment strategist of Leuthold Group. The company advises big money managers about key long-term trends that influence stock market returns. The current environment reminds Leuthold of summer 1987:

“The two things Wall Street was talking about to support the market before the terrible October [1987] decline was the huge amount of liquidity and the big shrink in equities. Then liquidity was coming from Japan, because Japanese brokers had started selling U.S. stocks. The big equity shrink was partly the result of LBOs, but mostly from companies buying back their own stock. There were other parallels. Breadth was deteriorating and investors were gravitating to big-cap stocks from small-cap stocks. There was an acceleration of inflation, which we are seeing now. There was an acceleration of interest rates, and the market kept going up in the face of higher rates, although, back then, the rise in rates was greater. There were a lot of similarities.”

Compare the S&P 500 and the long-term Treasury yield in the year leading up to June 1, 1987, and June 1, 2007, respectively. While long-term yields had spiked to a much-higher 9.1% by June 1987 -- compared with the recent 5% -- the parallel trends are clear. As Leuthold says, thus far in 2007, the market is “going up in the face of higher rates”. History never repeats exactly, but it often rhymes.

Harvey Sawikin from Firebird Management, noted that most of his hedge fund peers had become very cautious about the stock market by late 2006. Values had become harder and harder to find. But this year’s first half “melt-up” (minus the Feb. 27 hiccup) indicates that most money managers have been buying stocks aggressively since then. Leuthold addresses this phenomenon:

“At the end of 1986, institutions thought the market was overvalued and they became cautious. Then the market had a big move up in January 1987 and people were sitting there with defensive positions and thought, ‘Uh-oh, the market is going up.’ And it kept going up. Finally, there was a point of capitulation as managers who were lagging behind the S&P 500 and their peers threw in the towel and bought stocks. We haven’t seen that happen yet this time around. We could see it happen pretty soon. We’ve already seen it happen with the hedge funds, which, if you look at the [International Strategy & Investment Group’s] numbers, are about as long as they could get.”

The real factor behind the wave of private equity deals is bond investors’ insatiable appetite for income and their complete disregard for default risk. I agree with Leuthold’s expectations about most private equity firms’ motives: “The negative stuff is going to come when two years or three years or four years down the road, private capital attempts to regurgitate these companies and sell them back to the public after they have stripped all the assets out of them or taken their big dividends.”

Be prepared for a market correction this late summer. Last year was sell in May and go away. Now the market is being fed by the increasing money supply. But eventually the momentum will stop when the consumer is done spending. With inflation raising it's ugly head again the market will take notice.