Record S&P 500 Return on Equity Over Bond Yields Spurs Bulls

Standard & Poor’s 500 Index companies are returning more than ever in earnings compared with their borrowing costs, a signal that takeovers and capital spending will help investors overcome a slowing U.S. economy.

Return on equity, a measure of profits relative to investments in plants and labor, rose to 24 percent last month, according to data compiled by Bloomberg. At the same time, a gauge of corporate bond yields fell to 3.61 percent, according to Barclays Plc. That’s the biggest difference in at least 13 years, the data show.

Cost cuts and the lowest Federal Reserve interest rates on record are creating an unprecedented opportunity for executives to boost earnings by buying other companies or expanding their own businesses, according to Credit Suisse Asset Management. For BNP Paribas Investment Partners, low borrowing costs and high rates of return are a sign profits will overshadow the economy and budget deficit, spurring more gains in the S&P 500.

“Because the spread is so high and the value of M&A deals is still low compared to what we’ve seen in the past, it means we can expect that there’s going to a very decent volume of activity,” said William De Vijlder, who oversees $778 billion as the global chief investment officer of Paris-based BNP Paribas Investment Partners. “You should see people factor in a premium for takeover candidates, and that would increase the price-to-earnings multiple for stocks.”

Widening Out

The last time the difference was at similar levels, the S&P 500 was eight months into a bull market in which it doubled in five years. The gap between return on equity and yields narrowed in October 2008, a month after Lehman Brothers Holdings Inc. collapsed and quarterly profit for companies in the S&P 500 was tumbling 61 percent.

The potential to make profitable buyouts is increasing, according to Vijlder. He’s betting on a rebound in equities this year as economic growth accelerates and President Barack Obama reaches an agreement with lawmakers over raising the $14.3 trillion federal debt limit.

Takeovers totaled $160.4 billion between April and June, about the same amount since the end of 2009, according to data compiled by Bloomberg. That’s less than half the total in the second quarter of 2007, when the S&P 500 climbed as high as 1,539.18.

Worst Recession

The worst recession in seven decades spurred chief executive officers to cut staff and close factories, sending estimates for margins, or net income divided by sales, up by more than 50 percent since 2009, the biggest increase on record, data compiled by Bloomberg show. Corporate profits have been helped after the Fed kept its target rate for overnight loans between banks near zero since December 2008.

The S&P 500 dropped 2.1 percent to 1,316.14 last week after Moody’s Investors Service and S&P placed the U.S. credit rating under review for a downgrade and sovereign debt concerns spread from Greece to Italy and Ireland. The index slumped 0.8 percent to 1,305.44 today, before more than 100 companies in the S&P 500 release quarterly results this week.

“The environment at the moment is quite volatile, but we still have quite an optimistic view on the market, and one of the drivers should be more M&A,” said Adrian Zuercher, who helps oversee $150 billion in asset allocation strategies at Credit Suisse Asset Management in Zurich. “M&A is usually done at a premium, so it shows increasing demand for equities, and then there’s a new buyer in the market.”

Paring Losses

The S&P 500 trimmed its weekly loss on July 15, rising 0.6 percent, following takeovers. Petrohawk Energy Corp. (HK) rallied 62 percent after BHP Billiton Ltd. (BHP), the world’s largest mining company, agreed to buy the Houston-based natural gas producer for $14.9 billion. Clorox Co. (CLX) gained 8.9 percent on the same day as billionaire investor Carl Icahn offered $11.6 billion to purchase the Oakland, California-based maker of bleach.

Zuercher says S&P 500 companies will use cash for deals. Excluding financial institutions, the group has $788.8 billion, according to data compiled by Westport, Connecticut-based Birinyi Associates Inc. Cephalon Inc. (CEPH) and Temple-Inland Inc. (TIN) have surged more than 36 percent since receiving bids this year.

More gains in stocks are unlikely because the housing market and rising unemployment will prove a drag on the economy, according to Michael Vogelzang, who oversees $1.9 billion as chief investment officer at Boston Advisors LLC. He said he’s “underweight” equities and bullish on gold.

‘Big Problem’

“We don’t see any catalyst for upside given all the problems on the horizon,” Vogelzang said in Bloomberg Television interview. “Our big problem starts with housing and it ends with unemployment, and until those two things get taken care of, we’re going to have a tough time.”

The S&P/Case-Shiller index of property values in 20 cities fell 4 percent in April from a year earlier, the biggest drop in 17 months, according to data released June 28. The U.S. unemployment rate rose to 9.2 percent in June, the highest level this year, the Labor Department said July 8.

The S&P 500 has decreased 3.5 percent since climbing to a high of 1,363.61 on April 29 amid concern economic growth is faltering. Economists’ median forecast for growth in U.S. gross domestic product in 2011 has dropped to 2.5 percent from 2.7 percent in May, and the median for 2012 has declined to 2.9 percent from 3.1 percent, according to Bloomberg surveys.

GDP Slowdown

Concern a slowdown in GDP will constrict earnings has held equity valuations below historical levels. The S&P 500 trades for 13.2 times analysts’ estimate for profit this year, 9.7 percent less than the average since the start of 2006, according to data compiled by Bloomberg. Income in the gauge will climb to an all-time high of $106.60 a share in the next 12 months, estimates compiled by Bloomberg show.

Biotechnology companies in the S&P 500 have gained 9.4 percent since March 29, when Valeant Pharmaceuticals International Inc. (VRX), Canada’s largest drugmaker, made a $5.7 billion hostile bid for Cephalon. The deal for the Frazer, Pennsylvania-based producer of pain medication was trumped by a $6.8 billion offer from Teva Pharmaceutical Industries Ltd. (TEVA), the world’s biggest generic-drug maker.

Temple-Inland has jumped to the highest level since October 2007 after International Paper Co. (IP) made a $3.31 billion unsolicited bid for the Austin, Texas-based manufacturer of containerboard on June 6. Today, Temple-Inland’s board said it rejected the proposal from the largest pulp-and-paper maker.

Smaller Companies

Speculation that smaller companies may be acquired is spurring bigger gains for the Russell 2000 Index (RTY), said Don Wordell of Atlanta-based RidgeWorth Capital Management, which oversees $48 billion. The Russell 2000 of companies with a median market value of $547.5 million has risen 5.8 percent this year, compared with the 4.7 percent gain for S&P 500 stocks, which have a median worth of $12 billion.

Wordell said he’s betting on an increase in U.S. takeovers over the next two to three years and purchased shares of Lazard Ltd. (LAZ) in the past month. The Hamilton, Bermuda-based merger adviser has fallen 15 percent this year, pushing its valuation to 14.1 times estimated 2011 profit, Bloomberg data show.

“If large companies can’t grow organically, then they can go out and buy growth, and it’s really teeing up beautifully for them right now with borrowing costs being as low as they are,” said Wordell, who runs the RidgeWorth Mid-Cap Value Equity Fund that’s beaten 93 percent of its peers in the past five years, according to data compiled by Bloomberg. “I absolutely think it’s a theme that you’ll see.”

To contact the reporter on this story: Lynn Thomasson in Hong Kong at lthomasson@bloomberg.net

To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Nick Gentle at ngentle2@bloomberg.net

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