Stocks Beat Bonds in Value as U.S. Profit Yields Jump
The biggest decline for global equities in 15 months has left stocks at the cheapest level relative to bonds since the collapse of Lehman Brothers Holdings Inc., a sign that shares in the U.S. and Europe may rally.
Standard & Poor’s 500 Index companies yielded 4.4 percentage points more in profit than the average interest rate on investment-grade bonds last week, according to data compiled by Bloomberg and Barclays Plc. The inflation-adjusted spread shows stocks are trading near the lowest prices compared with corporate earnings since November 2008 next to bonds.
Cliff Remily at Thornburg Investment Management, which oversees $57 billion, and Barry Knapp of Barclays say the yield gap shows shares are too cheap to pass up with corporate profits forecast to rise the most in 16 years. While bears say the S&P 500 will tumble as Europe’s debt crisis curbs global growth, rising profit yields in stocks over bonds may provide a margin of safety for investors after $6.11 trillion was erased from equity markets worldwide since April 15.
“From a valuation perspective, you’ve got a little bit of the best of both worlds,” said Leo Grohowski, who oversees $157 billion as chief investment officer at BNY Mellon Wealth Management in Boston. “Bond yields are still low,” he said. “But earnings estimates are still at levels that are baking in an economic recovery. Something may have to give.”
U.S. stocks are dropping at the fastest rate since the S&P 500 bottomed at a 12-year low in March 2009 as European nations from Spain to Greece struggle to convince investors they can close their budget deficits. Even so, with a market value of $13.3 trillion, American shares exceed the combined worth of Japan, China, the U.K., Canada, France and Switzerland.
Analysts have lifted their average 2010 earnings growth forecasts for the S&P 500 to 32 percent from 26 percent at the end of March even as the benchmark measure of U.S. equities retreated 13 percent between April 23 and June 4, according to data compiled by Bloomberg. The index slipped 0.2 percent to 1,089.63 today.
S&P 500 companies have reported per-share profit during the past year totaling 6.3 percent of the index’s current price, topping the average interest rate of 4.5 percent for investment grade corporate debt in the U.S., data from London-based Barclays show. Profit yields for S&P 500 companies averaged 6 percent since 1954, based on the median compiled by Bloomberg.
The spread between the Stoxx Europe 600 Index’s income yield and the payout on 10-year German bunds widened to 4.5 percentage points last week, near the highest since 2008.
American shares last had an advantage this big two months after New York-based Lehman Brothers collapsed in September 2008, intensifying the worst financial crisis since the Great Depression. Four months later, in March 2009, the S&P 500 began the biggest rally since the 1930s.
Equities are also paying out more than government bonds. Ten-year Treasuries yield 5.3 percentage points less than the S&P 500 when adjusted for the annual increase in consumer prices, the most since March 2009.
The S&P 500 rose 2.5 percent to 1,091.60 last week, the biggest increase since March, while the Stoxx Europe 600 climbed 2 percent to 249.46 for its third straight gain. Strategists at 13 securities firms say the S&P 500 will rally 16 percent from last week’s close to end the year at 1,268, according to the average estimate in a Bloomberg News survey.
A chart pattern known as an inverted head and shoulders, centered around the March 2009 intraday low of 666.79, shows the index may reach about 1,240, data compiled by Bloomberg show.
“Against other asset classes, equities look really cheap,” said Knapp, head of U.S. equity strategy for Barclays in New York. “It could mean that we’re completely wrong on the inflation outlook, which means it’s going to get much worse, much faster. Or it could mean that stocks are decidedly cheap and people are overly cautious.”
Interest rate increases from central banks and faster inflation may erode the yield advantage for equities, proving stock bulls wrong. Policy makers boosted benchmark borrowing costs in Brazil and New Zealand last week.
The Federal Reserve’s target interest rate for overnight loans between banks is forecast to rise to 0.5 percent in the first quarter of 2011, from the zero to 0.25 percent range that’s been in place since December 2008, according to the median estimate in a Bloomberg News survey of 65 economists.
Fed Chairman Ben S. Bernanke said June 8 that policy makers may have to raise the rate before the economy returns to “full employment.”
While debt investors in Europe punish nations from Greece to Spain for deficit spending by pushing up bond yields, Treasury rates of all maturities have fallen to an average of about 2 percent from 2.75 percent a year ago even as the amount of marketable debt outstanding increased 20 percent to $7.96 trillion.
David Macia, a money manager for Credit Andorra’s asset management unit overseeing about $6 billion, says the valuation gap between bonds and stocks will narrow because earnings estimates are too optimistic and benchmark interest rates are at a record low.
“If you think profits are going to run at those levels, then the economy will likely be doing much better too, so we should see higher interest rates that will act as a counterbalance,” Macia said in an interview from Andorra La Vella, Andorra. “This is an anomaly created by rates that are too low. It’s a paradox.”
Remily, who manages the $4.86 billion Thornburg Investment Income Builder Fund that’s beaten 98 percent of rivals in the past five years, is finding value in Entergy Corp., the second- largest operator of U.S. nuclear power plants. Shares of the New Orleans-based company yield 9.3 percent in profit from the past year and 4.4 percent in dividends. That compares with Entergy’s most recently traded corporate bond, its 5 percent note due in 2018 that yielded 4.75 percent on June 10, according to Trace.
“It shouldn’t trade at that level of a risk premium because it’s a utility,” Remily said in an interview from Santa Fe, New Mexico. “You’re getting a business that grows slowly, but you’re not paying much for it. In general, we’re finding a lot of good opportunities.”
Total SA, Europe’s second-largest oil producer by market value, was the fund’s sixth-biggest holding as of April 30. The shares have fallen 12 percent this year, pushing its earnings yield to 9.9 percent and dividend payout to 5.8 percent. The 3.125 note from the Paris-based company due in 2015 yields 2.85 percent, Bloomberg data show.
Fujitsu Ltd., Japan’s biggest computer-services provider, has an earnings yield of 7.9 percent and pays a dividend of 5 yen a share twice a year. Tokyo-based Fujitsu’s 3 percent notes due in 2018 yield 1.18 percent, according to Bloomberg prices.
“If earnings are not going to fall apart, equities are priced very attractively to bonds,” said Tristan Hanson, manager of asset allocation and strategy in Jersey, Channel Islands, at Ashburton Ltd., which oversees $1.7 billion. “The world’s not without risk, but the odds have moved in your favor.”