(Bloomberg) - The economic cycle is advancing to a point where valuations may finally matter again for stock and bond investors.
Fortress-like in their refusal to bend for the better part of a decade, both asset classes have come under pressure thanks to the ever-stiffening resolve of central banks to restore order to the global economy. The S&P 500 has dropped in five of the last six days while yields on 10-year Treasury notes is set to break a streak of seven straight increases.
While interest-rate hikes get all the press, an equally big problem for bulls is valuations, with years of price appreciation leaving equities and fixed-income at nosebleed altitudes relative to cash flows.
A novel way of measuring the bloat was proffered in a note by JonesTrading, which added together the S&P 500’s earnings yield and the interest rate on 10-year Treasuries. Combined, the total yield -- what the firm called its “reverse Fed model” -- stands at 7.2% today, even with the runup in bond rates. That’s lower than 93% of the time since data began in 1962.
Worse, income from the assets is dwindling due to inflation. With consumer-price increases running at 8.5%, it’s the first time in six decades that the combined asset yields have sat below the inflation rate.
“Historically, investors have been more diligent to reprice stocks and bonds to ensure there is reward for taking on the added risk,” Michael O’Rourke, chief market strategist at JonesTrading, said in an interview. “The market believes the Fed will blink at the first sign of asset price weakness.”
That two major financial assets are so richly priced conceivably creates trouble for investors who just endured their worst quarter in decades, going by the breadth of losses across markets. Stocks and bonds have fallen this year in a rare concerted selloff as the Federal Reserve turned hawkish, embarking on what’s expected to the most aggressive rate-hike cycle since 1994.
At 4.4%, the S&P 500’s earnings yield -- the higher-is-cheaper reciprocal of the more widely followed price-earnings ratio -- sports one of the lowest readings in decades. The rate on 10-year Treasuries, despite reaching a three-year high of 2.78% Monday, offers less than half what it has done historically.
Stocks look expensive as well based on other metrics. Roughly 17% of members in the Russell 3000 Index are trading at more than 10 times their revenues, a proportion that exceeded even the dot-com era, according data compiled by Strategas Securities.
“While it is true that the share prices for many of the high flyers are down dramatically, there could be more room for them to decline,” said Ryan Grabinski, a strategist at Strategas. “One has to wonder how much investors will be willing to pay for these speculative names when the cost of capital is no longer free. Not to mention many of these companies produce zero profits and more often than not, require additional capital to fund their businesses.”
For his “reverse Fed model,” O’Rourke at JonesTrading adapted a framework that according to a July 1997 report by the central bank compares the relative value of stocks and bonds to identify a more attractive asset.
In the eyes of O’Rourke, both assets are priced as if they are in a bubble, inflated by an unprecedented period of Fed monetary support. To prove his point, he summed up the yields from Treasuries and stocks to show how little investors are getting nowadays relative to history.
The approach is a smart way to present cross-asset valuations, according to Ed Yardeni, the president of Yardeni Research Inc. who coined the term “Fed model.”
“I view the model as a clever spin on valuation in the capital markets for both stocks and bonds,” Yardeni said. “It’s a useful addition to the collection of valuation models.”
To be sure, inflation isn’t an unambiguous negative for equity investors. Corporate America has ridden rising prices to record profits, a trend that if it persisted could allow earnings to grow into stretched multiples. And the issue of bubble-like valuations can get resolved over time.
But the market might not have the luxury to wait it out. Thanks to an equity rebound, financial conditions have eased since the Fed in March raised interest rates for the first time since 2018. To O’Rourke, that’s a sign that central bankers need to toughen up.
“Once the market believes the Fed won’t blink, assets will likely re-rate lower,” O’Rourke said. “The Fed needs to be cognizant of that reality.”
By Lu Wang
