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Rebounding Stocks Lose Ground to Bonds as Yield Spread Drops

Updated on
  • Gap between bond rates and S&P profit yield widest since 2010
  • Outlook for a December Fed rate hike also fueling investors

Why Earnings Yield and Bond Yield Spread is Shrinking

The valuation advantage held by equities over bonds has slipped to the lowest level in five years as growth in earnings struggles to keep up with stock prices.

Rising bond payouts and stagnating profits are narrowing the spread between rates in the Bloomberg U.S. Corporate Bond Index and the earnings yield for the Standard & Poor’s 500 Index. The advantage has shrunk to the narrowest since 2010 as U.S. companies head for a second straight quarter of earnings contraction.

Picturing corporate profits as a yield and comparing them with fixed-income payouts is a way of judging relative value between the asset classes that has roots in a concept called the Fed model popularized in the 1990s. While it shows equities remain cheap compared with almost any time prior to 2008, the discount implied in share prices is decreasing.

“People haven’t really had the yield incentive to buy bonds over stocks,” said Bill Schultz, who oversees $1.2 billion as chief investment officer at McQueen, Ball & Associates Inc. in Bethlehem, Pennsylvania. “But that’s quickly changing as valuations push the upper end of the range.”

The narrowing gap also reflects changing sentiment around Federal Reserve benchmark interest rate guidance. After Fed Chair Janet Yellen said on Nov. 4 that a December interest rate hike remains a “live possibility” and economic data showed the best payroll growth of 2015, corporate bonds tumbled, boosting the yield in a basket of investment-grade debt by 11 percentage points over four days.

Meanwhile, stocks have gained 9.9 percent since falling to a 10-month low on Aug. 25, stretching valuations even as the catalysts for the summer swoon continue to damp expectations for economic growth and earnings. The S&P 500 declined 0.1 percent to 2,050.44 at 4 p.m. in New York.

Doug Ramsey, the Leuthold Weeden Capital Management LLC chief investment officer whose bearish research foreshadowed the U.S. stock market’s first correction since 2011, says the rebound that has lifted equities since the summer doesn’t mean the mispricings that drove the rout have gone away.

The index is trading at 1.8 times sales, about where it was in August, while industrial stocks last week were priced at 20 times earnings, the most in more than a decade.

These valuations, which have been above historical averages for months, are being pushed higher as revenue and profits decline, Ramsey said. After falling on a year-over-year basis in the first two quarters of 2015, revenue growth in the S&P 500 is forecast to contract 4.1 percent in the third quarter and 2.6 percent in the final three months of the year. Until the first quarter of this year, the measure hadn’t gone negative since 2012.

Profit expansion in the S&P 500 has ground to a halt, as third-quarter earnings for S&P 500 companies are expected by analysts to decrease by 3.7 percent. That follows a 1.7 percent contraction in the second quarter. 

To Schultz, an exodus from U.S. stocks into their fixed-income counterparts isn’t an immediate threat to the S&P 500, but it very well could be if corporations don’t do something to boost the slowdown in profit growth.

“We either need earnings to go up or prices to go down to normalize the P/E pressure,” he said. “Investors are looking to allocate more to fixed income and are seeking the right entry point. We still have a bit of a ways to go, but we’re moving in the direction where you might start seeing some movement across asset classes.”

(Updates with Tuesday S&P 500 move in sixth paragraph.)
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