Inflating stock and bond valuations are catching up with the bull market
(Bloomberg) – The economic cycle is progressing to a point where valuations may finally matter again for equity and bond investors.
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Fortresses in their refusal to relent for much of the decade, both asset classes have come under pressure from central banks’ ever-increasing determination to restore order to the global economy. The S&P 500 has fallen in five of the past six days, while 10-year Treasury yields are expected to break a streak of seven consecutive increases.
While interest rate hikes get all the press, an equally big issue for bulls is valuations, with years of price appreciation leaving equities and fixed income at bleeding altitudes relative to cash flow.
A new way to measure bloat was proposed in a JonesTrading note, which added the S&P 500 earnings yield and the interest rate on 10-year Treasury bills. Combined, the total return — what the firm has called its “inverted Fed model” — stands at 7.2% today, even with bond yields rising. That’s less than 93% of the time since the data began in 1962.
Worse, asset income declines due to inflation. With consumer price increases of 8.5%, this is the first time in six decades that combined asset returns have fallen below the rate of inflation.
“Historically, investors have been more diligent in repricing stocks and bonds to ensure there’s a reward for taking the extra risk,” said Michael O’Rourke, chief market strategist at JonesTrading, in an interview. “The market thinks the Fed will blink at the first sign of asset price weakness.”
The fact that two major financial assets are priced so high in theory creates problems for investors who have just suffered their worst quarter in decades, due to the scale of the losses in the markets. Stocks and bonds have fallen this year in a rare concerted selloff as the Federal Reserve turned hawkish, embarking on what is expected to be the most aggressive rate hike cycle since 1994.
At 4.4%, the S&P 500 earnings yield — the highest reciprocal is the cheapest of the most widely followed price-earnings ratio — is posting one of the lowest readings in decades. The 10-year Treasury yield, although hitting a three-year high of 2.78% on Monday, is offering less than half of what it has historically.
Stocks also look expensive based on other metrics. According to data compiled by Strategas Securities, about 17% of Russell 3000 Index members trade at more than 10 times their earnings, a proportion that surpasses even the dot-com era.
“While it’s true that the stock prices of many of the biggest robbers have fallen dramatically, there may be more room for them to decline,” said Ryan Grabinski, strategist at Strategas. “One has to wonder how much investors will be willing to pay for these speculative names when the cost of capital is no longer free. Not to mention that many of these businesses do not produce any profits and more often than not require additional capital to fund their operations. »
For his “Reverse Fed Model,” O’Rourke of JonesTrading adapted a framework that, according to a July 1997 central bank report, compares the relative value of stocks and bonds to identify a more attractive asset.
In O’Rourke’s eyes, both assets are priced as if they were in a bubble, inflated by an unprecedented period of monetary support from the Fed. To prove his point, he summarized the returns of Treasuries and stocks to show how little investors are earning these days compared to history.
According to Ed Yardeni, president of Yardeni Research Inc., who coined the term “Fed Model,” this approach is a smart way to present cross-asset valuations.
“I see the model as a smart twist on capital markets valuation for stocks and bonds,” Yardeni said. “It’s a useful addition to the collection of assessment templates.”
Admittedly, inflation is not an unambiguous negative for equity investors. Corporate America pushed higher prices to record earnings, a trend that, if continued, could allow earnings to grow in stretched multiples. And the problem of bubble-like valuations can resolve over time.
But the market may not have the luxury of waiting. Thanks to a rebound in equities, financial conditions have eased since the Fed raised interest rates in March for the first time since 2018. For O’Rourke, it’s a sign that central bankers need to get tough .
“Once the market believes the Fed won’t blink, assets will likely reprice lower,” O’Rourke said. “The Fed needs to be aware of this reality.”
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