- Falling stocks show perils of timing market with valuations
- Fed warns of other risks associated with valuing equities
The dangers of relying on valuation as a tool for market timing are on display right now in U.S. equities.
At issue is something known as the Fed Model, a comparison of stock and bond yields that has been pointing bulls to equities for three months. As bond yields fell from their March highs, an investor guided by the theory would have bought shares, betting they’d rally as money flowed into them from fixed-income.
As the last two days have shown, signals like this don’t always work. Stocks have plunged following the U.K. vote to secede, while bonds rallied and yields reached an almost four-year low. Stocks that were cheap in comparison to Treasuries have gotten significantly cheaper, a lesson that cost U.S. investors billions of dollars in lost market value.
“In a world where there’s so much uncertainty and so many questions, these valuation metrics break down entirely,” Yousef Abbasi, global market strategist at JonesTrading Institutional Services LLC in New York, said by phone. “It becomes so difficult to decipher whether you’re being appropriately compensated for the risk you’re taking. Lower rates create the valuation gap where you think equities can go higher, but right now it’s safety above all.”
The Fed Model is cited as justification by bulls for stock prices that look elevated according to conventional metrics. The argument goes like this: at more than 18 times annual earnings, the S&P 500 is roughly the most expensive it’s been since the internet bubble. Compared with bonds, however, which are presumed to compete for investor dollars, they don’t look so bad.
As shares fall and bonds rally, the tool, which plots the valuation advantage of equities over Treasuries, widens. After the 5 percent drop of the last few days, the S&P 500 earnings yield reached 5.41 percent. That’s 3.96 points above the Treasury rate, close to the highest point this year and near record levels.
But wait. If you liked stocks last week, shouldn’t you love them now? Not so fast. Among skeptics questioning the model’s usefulness in sounding an all-clear signal for stocks is Janet Yellen, who warned last week in the Federal Reserve’s report to Congress that the comparison might be overstating the attractiveness of equities.
The hazard is that should there be a sudden normalization in debt market term premiums, or the extra compensation demanded by investors to hold longer-term bonds over ones with shorter maturities, equities will be particularly susceptible, according to the Fed.
“Although equity valuations do not appear to be rich relative to Treasury yields, equity prices are vulnerable to rises in term premiums to more normal levels,” the Fed report said. “Especially if a reversion was not motivated by positive news about economic growth.”
With Treasury yields approaching 1.40 percent Monday, rising rates seem like the least of anyone’s problems. Still, should yields start to rise with economic growth still sluggish, the Fed’s warning would be relevant to equity owners, according to Alex Bellefleur, head of global macro research and strategy at Pavilion Global Markets.
“If it were to rise because of some exogenous factor -- ECB stopping QE, an economic shock or a huge wave of Treasury selling -- I could see how she’d be right,” Montreal-based Bellefleur said by phone. “It’s an interesting comment, it’s based on this idea that higher 10-year yields and higher term premia are generally bad for equity valuations.”
Yields on long-term bonds encompass traders’ expectations of the path ahead for short-term rates -- which is driven by the outlook for Fed policy, economic growth and inflation. Added to that is a term premium, or extra compensation given the risk that these projections may prove wrong or that rates will be swayed by other unforeseen forces over the life of the bond.
That premium has been negative for much of 2016, after falling below zero for the first time in four decades in 2012. Since 1980, the 10-year term premium according to one model has averaged about two percentage points. When the premium is at or above that level, the S&P 500 has an average price-earnings ratio of 16.2, or about 12 percent below its current reading, according to data compiled by Bloomberg.
Bond yields still have a long way to go before they’re a compelling alternative to stocks, according to research by Bellefleur. Treasury yields become “detrimental” to stock valuations when they’re above 5.5 percent, according to a May 23 note by Pavilion.
“The market is where people are putting their money because interest rates are so low domestically and internationally that there’s nowhere else to put money,” Stephen Carl, principal and head equity trader at Williams Capital Group LP, said by phone. “If there is a spike in yields that would present an avenue for people to be able to diversify.”