A Top Bond Strategist Looks at Stocks and Recoils
I am solely a U.S. interest rate strategist, so it is with no shortage of anxiety that I dare delve into the equity market, which hit new highs again today. I’m typically bullish on bonds and bearish on stocks, so what follows panders to a career bias. With that out of the way, I do look at the evidence, and there are things out there that make me wary of equity valuations which, all things being equal, should serve as a brake of sorts on a sharp rise in bond yields.
The equity gurus cite various broad perspectives such as price-to-earnings ratios on the S&P 500, both trailing and forward-looking, and variations on that theme. I like to look at the offbeat, noting that it might raise fewer challenges to my analysis. Take the actual cost of a share of the S&P 500 in terms of what it would take an ‘average’ American to buy it.
Using average hourly earnings, one would have to work 108.3 hours to buy a share of the S&P 500. That is only slightly above the March 2000 peak of 107.8 hours and well above the peak prior to the last recession of 89.8 hours. A market technician looking at a chart of this might express caution about a double top forming, meaning that a pattern is about to reverse. So at least by this measure, it’s fair to argue that stocks cost a lot of money to the average American, which is probably one of the reasons many Americans don’t actually own stocks. A recent Gallup Poll puts the figure at 52 percent, the lowest level in Gallup’s 19-year trend.
The big buyers, of course, have been the companies themselves. The Federal Reserve’s Flow of Funds data shows that net equity issuance for the first three quarters of last year was negative $1.295 trillion, following on negative $1.32 trillion for all four quarters of 2015. (Net Equity Issuance is simply the change in the net dollar amount of shares outstanding. A negative figure means that either the shares were bought in buybacks or through M&A action.) That’s an awful lot of working hours if you think about it. There is a flipside to this that I’ll get to in a moment.
The P/E ratio for the S&P 500 is 25.9, the highest it’s been since 2010, and with the exception of the spikes that occurred in the extraordinary days that followed the financial crisis, the ratio was last at that level in 2004. So, again, rather high.
Another way of looking at this is through Yale professor Robert Shiller’s cyclically adjusted price-earnings measure, which is the price divided by the 10-year moving average of earnings adjusted for inflation, thus giving it a longer time-frame. That stands at 28.2, just over the peak it reached from 2003 to 2007. That said, it bounced up to that level with only minor pullbacks for those four years.
Another cause for my concern is the caution that the equity market shows in volatility measures. With valuations arguably extended and, let’s just say, a degree of discomforting spontaneity stemming from the White House, why is the VIX so low? (The VIX is an index put out by the CBOE that measures the implied volatility of S&P 500 options, also known as the “fear index.”) At 10.6, it is basically at its post-crisis lows.
A related index is the CBOE’s SKEW that measures tail risk based on out-of-the-money options. On January 20 it rose to its second-highest level ever, but has subsequently eased back. Am I the only one anxious?
I earlier mentioned a flipside to negative net equity issuance, which is that the buybacks have come at the expense of massive corporate borrowing, a subject my colleagues at Informa Global Markets follow intensely. To wit, there’s been an explosion of corporate issuance which in turn should create at least some concern with the overall size of corporate indebtedness.
Outstanding corporate debt as a percent of gross domestic product is 45.2 percent. That’s the second highest in history, marginally surpassed by the 45.6 percent recorded in the first quarter of 2009 and almost reached again in the fourth quarter of 2001. Those dates ring any bells? They were the height of the last two recessions. And that’s especially notable because the excuse for such a high percentage during a recession comes on the back of weaker, negative, GDP. The current level comes with GDP growth, and so is a function of the increase in issuance.
Do I need to mention that this borrowing has been for buybacks and the like, but not for the sort of investment that enhances productivity or expands the economy? The most recent statement from the Federal Reserve’s Federal Open Market Committee, which was otherwise somewhat optimistic, noted “business fixed investment has remained soft.” This is rather late in the business cycle to see such a comment.
Related to that are corporate interest payments. Non-financial corporate interest payments are 2.75 percent of GDP, or 1.9 percent on a net basis. The net payments are near a peak and the overall is remarkably high considering how much corporate yields have come down. You’d think the payments would have followed rates more closely. That they haven’t raises the question of how much those payments rise when interest rates lift further and/or when spreads widen out. The easy call is that new issuance should decline, but in the event spreads widen due to a profit slowdown or recession, the high level of corporate indebtedness will exacerbate such widening.
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