S&P 500 Stocks Are Cheapest Ever Relative to Junk Bonds

Tuesday, 31 May 2011 03:11 PM

 

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The longest stretch of declines for the Standard & Poor’s 500 Index in a year has left valuations at the lowest level ever compared with speculative-grade debt.

Earnings from the past 12 months for companies in the benchmark gauge for U.S. equities reached 6.64 percent of share prices this month, according to data compiled by Bloomberg. That compared with the 6.61 percent average yield on junk bonds, data from Barclays Plc show. It was the first time the spread, a way of comparing debt and equity values, has shown stocks with a higher yield, according to Bloomberg data going back to 1987.

Concern the U.S. economic recovery will falter as the government reduces its unprecedented stimulus has sent the S&P 500 down four weeks in a row, reducing valuations relative to profits. When the gap with bonds approached this level in September, the stock index returned 19 percent in the next six months, doubling the return in credit markets.

“People will recognize that there is something of an anomaly there,” Paul Niven, the London-based head of multi- asset investments at F&C Asset Management Plc, which oversees 106 billion pounds ($175 billion) said in an interview on May 25. “You are better to be in equities than credit at this point of the cycle. There is a better valuation cushion.”

Greek, Irish Bonds

The S&P 500 fell 2.4 percent in May through last week, after rising to an almost three-year high, as data showed the slowest economic growth since the second quarter of 2010. The gauge lost 0.2 percent to 1,331.10 last week after applications for jobless benefits exceeded forecasts and an index of Chinese manufacturing dropped to a 10-month low. Greek and Irish bond yields reached the highest levels since the adoption of the euro on concern Europe’s debt crisis will worsen.

The Barclays index of 1,073 speculative-grade companies, which goes back to 1987, has returned 0.4 percent in May. Yields on bonds rated below Baa3 by Moody’s Investors Service and BBB- at S&P have dropped from a record 23 percent in December 2008 as Federal Reserve Chairman Ben S. Bernanke cut the target interest rate for overnight loans between banks to near zero and pledged to repurchase up to $600 billion in government bonds, a program that’s set to end next month.

The Barclays high-yield bond index gained 113 percent through last week, including coupon payments, since the Fed last lowered interest rates on Dec. 16, 2008. The S&P 500 returned 62 percent, when dividends are included. The S&P 500 climbed 0.9 percent at 9:44 a.m. in New York today.

Profit Growth

The S&P 500’s earnings yield has fallen from 9.89 percent at the start of the bull market in March 2009, while per-share profit has climbed six straight quarters.

Ford Motor Co. (F), based in Dearborn, Michigan, sold notes at 5 percent in April, the second-lowest coupon at the time for speculative-grade issues in 2011, Bloomberg data show. The second-largest American automaker has an earnings yield of 13.77 percent, using profit from the past year.

R.R. Donnelley & Sons Co. sold $600 million of seven-year, 7.25 percent notes on May 17, a day after the commercial printer’s debt rating was cut to junk. The Chicago-based company founded in 1864 has an earnings yield of 8.37 percent, Bloomberg data show.

John Paulson, whose New York-based hedge fund Paulson & Co. made about $5 billion in 2010, cited the spread between profit yield and U.S. Treasury rates as a reason to be bullish in a January letter to investors obtained by Bloomberg News.

Fed Model

The comparison is a variation on the so-called Fed model, which Edward Yardeni derived from a July 1997 report that showed the central bank used the technique to compare equity and Treasury valuations. Yardeni, who worked for Deutsche Bank AG at the time, now runs Yardeni Research Inc. in New York.

The S&P 500’s dividend yield, another valuation gauge, overtook rates on 10-year Treasuries in November 2008 for the first time since 1958. That preceded the start of a two-year bull market in equities that gave the S&P 500 a 111 percent return while Treasuries gained 6.1 percent, data compiled by Bloomberg and Barclays show.

“We don’t see a lot of potential in the credit market,” Zurich-based Thomas Steinemann, the chief strategist at Vontobel Asset Management Ltd., whose team helps oversee about $80 billion and doesn’t hold high-yield bonds, said in a May 26 telephone interview. “The Damocles’ sword of a Greek default may kill all risk assets, but the argument until then is in favor of equities.”

Flawed Techniques

Valuation techniques that assume profits won’t change over time are flawed, and high-yield bonds are a preferable investment to equities, said Andrew Milligan, who helps oversee $262 billion as Edinburgh-based head of global strategy at Standard Life Investments Ltd.

The S&P 500 was trading at 17.3 times annual profits at the end of 2007, near its historical average valuation after companies earned $84.67 a share. Compared with net income in the following year, when more than $2 trillion in credit losses spurred the first global recession since World War II and pushed earnings down to $60.57 a share, the multiple was 24.2.

“The Fed model works sometimes, and sometimes it doesn’t,” said Milligan, whose firm is “neutral” on equities and “overweight” junk bonds. “Corporate bonds are well protected at the moment. Companies have very good cash levels, and defaults are very low.”

Profit gains have kept valuations below their historical average. Per-share earnings in the index jumped 36 percent to $84.58 in 2010, Bloomberg data show.

Twice the Gain

Before 2011, the lowest spread between the earnings yield and junk bond payouts was set on Nov. 9, 2010, when it narrowed to 33 basis points, according to data compiled by Barclays and Bloomberg. The S&P 500 returned 12 percent in the next six months, while high-yield bonds gained 5.4 percent.

“Equities are mispriced relative to bonds,” said Brian Barish, Denver-based president of Cambiar Investors LLC, which oversees about $8 billion. “Companies with access to credit are being heavily encouraged by relative price levels to issue debt, to buy other businesses, or to buy back stock. There’s a very favorable relationship in terms of relative debt pricing versus implied equity valuations.”

Announced takeovers in which U.S. companies were the target totaled $395.4 billion in 2011 through last week, up 23 percent from a year earlier, according to data compiled by Bloomberg. Executives announced $195 billion in stock buybacks during the first four months of 2011, 56 percent higher than a year earlier, according to data compiled by Westport, Connecticut- based Birinyi Associates Inc.

Earnings Yield

Before this month, earnings yield had never risen above rates on junk bonds. The spread by which payouts on speculative debt exceeded equity profits has averaged 5.79 percentage points since 1987, Bloomberg data show.

Companies have sold $165 billion in junk bonds this year, poised for the most since at least 1999, according to Bloomberg data. Default rates have fallen to 2.5 percent in 2011, from 8.5 percent a year ago, according to S&P.

Toby Nangle, who helps oversee $54 billion as director of asset allocation at Baring Asset Management in London, said his model portfolio for U.S. institutional clients holds equities and no high-yield corporate bonds.

“High yield has had an astonishingly good run of performance, and with hindsight we should have been in it,” he said. “But we don’t find them as compelling now. Junk bonds should have a liquidity premium over equities.”

© Copyright 2014 Bloomberg News. All rights reserved.

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