THE WALL STREET ADAGE

for this time of year is, "Sell in May and go away." Yet our pundits found enough of interest to keep them focused on a market that's still prospering in its own uncertain fashion.

Rising 10-year Treasury yields, which on June 6 topped 5% for the first time since August 2006, briefly curbed enthusiasm for stocks and prompted widespread questions about the possibility that the Federal Reserve would raise interest rates. After initial jitters, the Fed on Thursday decided to keep rates in place at 5.25%, concluding that inflation remained its chief policy concern. Equity investors sighed relief. The S&P 500 index and Dow Jones Industrial Average are up nearly 8% and 6%, respectively, year to date through the end of June.

"Fed Chairman Ben Bernanke and company may not need to raise interest rates in the near future to combat inflation (headline or core) since the bond market has already boosted rates for them," wrote Charles Schwab's chief investment strategist, Liz Ann Sonders, on June 28. "The yield on 10-year Treasurys has risen from a low of 4.47% in mid-March to 5.11% today. It reached a high of 5.30% just two weeks ago. Consider it a 'stealth rate hike.'"

That's come about in large part because global economies are so profoundly interconnected, and because the U.S. is actually in pretty good shape, wrote Ed Yardeni, president of Yardeni Research, in a June 12 commentary.

"Bond yields rose in the U.S. recently because better-than-expected economic indicators suggest that the Fed won't ease as was widely expected. They also rose because bond yields have been moving higher overseas as many foreign central banks have continued to hike their official rates in reaction to better-than-expected economic indicators in their countries. Since foreign investors have become such big players in the U.S. fixed-income markets, the U.S. bond market has become more sensitive to interest rate developments overseas."

But bonds also prompted worries about further economic disruption following the apparent implosion of a pair of Bear Stearns hedge funds invested in mortgage-backed securities tied to troubled subprime loans. Pimco bond guru Bill Gross blasted the $3 billion bailout of the funds. However, he saw a credit-tightening upside to the possible fallout from the subprime mess, which he described in his monthly July commentary.

"Importantly, as well, and this point is neglected by most pundits, the willingness to extend credit in other areas high yield, bank loans and even certain segments of the AAA asset-backed commercial paper market should feel the cooling Arctic winds of a liquidity constriction. If not taken too far and there is no hint yet of a true 'crisis' these developments may be just what the Fed has been looking for: easy credit becoming less easy; excessive liquidity returning to more rational levels," according to Gross.

Jeffrey Kleintop, now chief market strategist for LPL Financial Services, wrote June 11 that bond moves were having an appropriate effect on equity markets that were three months into a rally, and that the pattern was a familiar one.

"At the halfway point in the duration of a rally, concerns typically surface that the stock market has moved too far, too fast and is ripe for a correction," he wrote. "These concerns by market participants tend to sustain the rally, as investors cautiously buy over time rather than all at once. Much like last year, the driver for the stock market dip was the sharp rise in bond yields."

The bond-market bump will carry over into stocks in another way, said Citigroup's Tobias Levkovich in a June 18 note.

"Several lead indicators, including equity risk premiums, bond yield curve steepness, and private sector credit growth, suggest that equity market volatility is likely to pick up further over the next 18-24 months, " he wrote. "Large-cap equity market leadership becomes more pronounced when volatility climbs and various sector and industry group stock prices will most likely be affected as well."

Stocks in the information-technology sector and in pharmaceuticals/biotechnology group have demonstrated consistent direct links to market volatility over the past two decades, and Levkovich wrote that higher volatility should lead to stronger stock-price performance. Sectors such as electric utilities, metals and mining, industrials, consumer services, and consumer durables and apparel will suffer, though, he added.

In the pre-rate-hike conditions most of our pundits described, equity investors can get a measure of defensive solace through large-cap stocks, advised Merrill Lynch strategist Richard Bernstein, whose June 12 report had a title that said it all: "Big becomes beautiful."

For more of what our pundits are saying, read their latest predictions here.