Why one investment manager says a correction is inevitable
Rising Treasury yields and the biggest equity market rally in 16 years are leading one measure of stock valuations to the most bearish level since 2011.
Profits as a percentage of Standard & Poor's 500 Index's price, known as earnings yield, totaled 5.76% last week, compared with the 2.86 percent payout on 10-year Treasuries, according to data compiled by Bloomberg. At 2.9 percentage points, the gap, which narrows as equities get more expensive relative to debt, is the smallest since March 2011.
The last time spreads between bond and earnings yields were this compressed, the S&P 500 posted its biggest retreat of the bull market, falling 19 percent between April and October 2011. The index hasn't lost 10% since then. Wall Street strategists have forecast the weakest share advance in almost a decade for 2014, as a reduction in Federal Reserve bond purchases pushes up Treasury yields from 1.75% at the end of 2012.
“We are due for a correction,” said Peter Sorrentino, who helps manage about $14.8 billion at Huntington Asset Advisors in Cincinnati and is buying options to protect against a decline in the stock market. “It's not a question of if, but how bad.”
Stocks fell the first three days of January, the longest stretch to start a year since 2005. The S&P 500 has lost 0.3% so far in 2014, compared to a 0.7 percent gain for government notes, data compiled by Bank of America Merrill Lynch and Bloomberg show. Yields on 10-year Treasuries will rise more than 0.55 percentage point by the end of the year, reaching 3.43%, according to the average of 64 economists surveyed by Bloomberg.
2013 RETURN
The index posted a 30% gain in 2013, beating government debt by 33 percentage points, the widest margin since at least 1978, according to data compiled by Bank of America Merrill Lynch and Bloomberg. U.S. bonds fell 3.4%, the first drop since 2009.
Analysts are the most bearish on individual companies since at least 2004 just as valuations for stocks from Alcoa Inc. to Tyson Foods Inc. have risen to an almost four-year high. Last year's rally helped push the S&P 500 earnings yield down about 1.3 percentage points as Treasury rates climbed the same amount, narrowing the gap by the most in four years, data compiled by Bloomberg show.
VALUATION TECHNIQUES
Stock earnings yields and bond rates are both valuation measures, showing how much owners are getting back in profits or interest payments on the money they invested. Income generated by S&P 500 companies hasn't fallen below Treasury rates for more than 11 years. The advantage for stocks was close to its most bullish level ever in 2012, according to data compiled by Bloomberg.
“At this point, equities are so highly valued that it's very hard to assume that there's going to be much more rotation” from bonds to stocks, Daniel Alpert, founder and managing partner at New York-based Westwood Capital LLC, said in a Jan. 6 Bloomberg Radio interview with Tom Keene. “Cash is a wonderful place.”
Walter Todd, chief investment officer at Greenwood Capital Associates LLC, says he's keeping more new money in cash than he did three to six months ago as he braces for a decline in equities. Thornburg Investment Management Inc.'s Jason Brady is buying bonds more aggressively, while Huntington Asset Advisors' Mr. Sorrentino is selling call options, a bet stock gains will be limited, to finance the purchase of protective puts.
“We are being more defensive going into this year,” Mr. Sorrentino said.
U.S. pensions, which control $16 trillion, shifted out of equities and into bonds in the third quarter at the fastest rate since 2008, latest data compiled by the Federal Reserve show.
Comparing earnings and bond yields is similar to an indicator known as the Fed model, derived by U.S. economist Edward Yardeni from a July 1997 report by the central bank. Critics such as AQR Capital Management LLC founder Clifford Asness have contended the technique doesn't work because inflation affects stock valuations and interest rates differently.
ECONOMIC GROWTH
S&P 500 profits will expand 9.5% in 2014, up from last year's 5.1%, according to analyst estimates compiled by Bloomberg. Improving economies around the world will also help push up stock prices, Ward said. Economists forecast the U.S., Japan and the euro area will all grow this year, the first time all three have expanded since 2010, data compiled by Bloomberg show.
The Fed, which has held its benchmark lending rate at zero since December 2008, said on Dec. 18, 2013 that it would cut its monthly purchases by $10 billion to $75 billion, citing an improving economy. The U.S. trade deficit shrank more than forecast in November, as orders for long-lasting goods climbed by the most in 10 months, reports showed. While job creation in December was less than economists forecast, the unemployment rate fell to 6.7 percent from 8.1 percent at the start of 2013.
Stock investors may have already reaped the benefits of this year's economic growth, according to Mr. Todd, who oversees about $950 million at Greenwood Capital in Greenwood, South Carolina.
Gross domestic product will expand 2.6% this year and pick up to 3% next year, according to 78 economists surveyed by Bloomberg. While that's faster than the 1.7% projected for 2013, Wall Street strategists aren't betting it will boost the S&P 500 by much. The index will expand 5.8% in 2014, the smallest projection to start a year since 2005, data compiled by Bloomberg show.
“There's no question that economic growth is ramping,” he said in a Jan. 7 phone interview. “But how much of that is already discounted in the market? For the longest time, it was the economy that was hard to call, but now it's the market's reaction that's the question.”
(Bloomberg News)
