Valuation trauma is refusing to end for S&P 500 in free fall
Posted On June 11, 2022
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American equities plunged to the worst week since January after data showed US price pressures hit a fresh 40-year high in May (Image: Bloomberg)
The stock market: buckling under the hottest inflation since 1981, battered by a historically aggressive bid to break it. Making matters worse is that bonds are beckoning as well. American equities plunged to the worst week since January after data showed US price pressures hit a fresh 40-year high in May, squashing hopes inflation had peaked.
Treasury yields soared to levels last seen in 2008 as traders braced for the possibility that the Federal Reserve will raise interest rates by 75 basis points next month after executing the first half-point hike since 2000.
Beyond just the real-time upheaval, one of the more tangible consequences of the central bank’s campaign has been to make fixed-income investments increasingly more attractive versus equities. One measure, a version of what’s known as the Fed model in which the S&P 500’s valuation is plotted against that of investment-grade bonds, is flashing ever-more worrisome signals for stocks.
Relative to its price, the S&P 500 “pays out” just under 5% in earnings as of Thursday, data compiled by Bloomberg show, versus the 4.4% average yield on investment-grade corporate bonds. The 0.54 percentage-point difference is the close to the slimmest advantage that equities have held over credit since 2010.
Juxtapositions like that are making it hard to dive back into riskier assets as investors size up which ones will bear the brunt of a hawkish central bank bent on cooling growth.
US blue-chip bond yields are closing in on S&P 500’s earnings yield (Chart: Bloomberg)
US blue-chip bond yields are closing in on S&P 500’s earnings yield
“In a downturn, earnings will be hit, which will impact equities directly, even if multiples don’t change, while the vast majority of investment-grade companies have plenty of room to avoid credit-rating downgrades,” said Peter Tchir, head of macro strategy at Academy Securities. “The corporate bond yield versus the S&P 500 dividend yield seems attractive to me outright, let alone when I’m worried about the economy.”
The S&P 500 sank 2.9% Friday, capping its ninth down week in 10, led by a selloff in richly valued technology shares, as consensus solidified that the Fed will have to double-down on tightening.
Yields on two-year Treasuries topped 3% for the first time since 2008 as economists at Barclays Plc and Jefferies both published calls for the Fed to boost rates 75-basis points at next week’s meeting. A hike of that size hasn’t been seen since 1994.
While the selloff has scorched every corner of stock and bond markets, fixed-income valuations have already priced in most of the risk, according to AlphaTrAI’s Max Gokhman. With high-grade bonds yields at the highest level since 2020, that’s a better place to be than equities, where there’s likely further repricing to be had, he says.
“There’s more room to drop for equities as stock investors are still in the denial stage about the Powell Put being gone and inflation being both a demand and supply shock,” Gokhman said. “Conversely, bond investors are wavering between the depression and acceptance stages. Sad as that sounds, it’s a better place to be.”
S&P 500 posts biggest weekly loss since January post-CPI (Chart: Bloomberg)
Not everything in fixed income is a screaming buy. US junk bonds command yields of 7.5%, also close to the loftiest levels since 2020, Bloomberg data show. However, that’s not yet enough to offset the risk that the Fed’s hiking cycle tips the economy into a recession, according to Wells Fargo Investment Institute’s Sameer Samana.
“It’s probably a bit soon to be aggressive with high yield exposure, given their economic sensitivity,” said Samana, the firm’s senior global market strategist. “Right now, we expect a mild, short recession as a base-case and 10% is probably in the right ballpark of discounting that scenario. But if the Fed makes a policy mistake and a longer, deeper recession is in the offing then 10% may not compensate for higher levels of defaults.”
Of course, versions of the Fed model are not infallible market-timing tools. When equities lost their earnings-yield advantage over investment-grade debt in 2009, the S&P 500 advanced by 23.5% that year, followed by a 12.8% rally in 2010.
Additionally, asset allocation isn’t a binary choice. For Morningstar chief investment officer Marta Norton, the magnitude of the decline in stocks with the S&P 500 nearing 18% year-to-date losses has opened up bargain-hunting opportunities. But yields not seen in years have the high-quality corners of the bond market looking attractive as well, she said.
“When we see equities off to the level that they’re off, we’re favoring modestly putting the marginal dollar towards equities,” Norton said on Bloomberg’s “QuickTake Stock” broadcast. “We’re also seeing high yields in the higher quality portion of the bond market, do that’s something that we’re also adding to our portfolio as well.”