Taking the market’s temperature
Posted on June 15, 2007 by Richard Beddard
Filed Under Markets |
Rising bond yields last week provoked another bout of paranoid punditry this week for the very good reason that the bull market in shares is fuelled in part by cheap debt. Suddenly private equity deals, takeovers and share buy backs look threatened because it’s more expensive to borrow the money that funds them. Since these activities shrink the supply of shares and drive up prices by taking whole companies or some of their equity out of the market, should we be worried? The Big Picture gives us six threats, and the Economist, three things to fret about. But I’m not so sure we need to worry, yet…
The reason is I’m following the spread between global bond yields and global earnings yields. In theory, while earnings yield more than bonds, equities are a more attractive investment and money will flow into company shares - good news for the stockmarket and explained in much more detail in ‘The boom must go on‘. The fact that rising bond yields narrow that spread adds credibility to the doom sayers, but it doesn’t mean the end is nigh.
I owe these insights to Ken Fisher, and Fisher Investments have sent me their latest calculations which include recent moves in the bond markets. Currently the 10-year world treasury yield stands at 4.6% and the MSCI world earnings yield is 6.6%, so the gap is 2%. Just to reach parity, bond yields must rise 2%, earnings must fall 30%, share prices must rise 44% or some combination of those must happen. At the end of last year the gap stood at 2.8% so it has closed a bit.
Ironically, while everyone’s talking about bond yields, very few commentators are making the comparison with earnings yield that can lend perspective to their worries. So with sentiment wavering and large moves required, it’s going to be some time before global bond yields and earnings yields return to parity. It could be even longer, though, until the next bear market, as in all probability the deals that are driving the bull market will continue, even though they’ve ceased to be economic, until there is a series of big failures.
Also in the past, stockmarkets have risen even though bonds appear cheaper. In fact, globally, the earnings yield has been higher than the bond yield since 2001, but, says Fisher Investments, before that it had never happened. Investors will buy company shares even if bonds appear cheaper because bonds are fixed interest, they return their coupon rate until they mature and that’s it. With equities there is the expectation of growing profits (earnings) over time.
So even though the gap between the earnings yield and the bond yield is a less obvious guide to the temperature of the market when the bond yield is the higher, the stock market is not necessarily doomed.
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Hi Richard,
I think I understand the theory which Ken Fisher is applying (i.e. buy back higher yielding shares with lower yielding bonds).
However it seems to me that the gap has closed by 1/3 in 6 months which seems quite a lot.
In addition, all the factors which Ken mentions seem to be happening and perhaps, each one feeds off the other.
Is there is a possiblity that this closure of the gap will accelerate?
Hi Robin,
The short answer is I don’t know (if it will accelerate). But it should be possible to take a view. You’re right the interactions feed off each other. Some act to close the gap. For example companies borrowing to take others over (or buyback shares) should push interest rates and bond yields up, closing the gap on earnings yields. Buying stock with borrowed money also reduces the supply of stock which forces share prices up, bringing the earnings yield down and closing the gap. However buybacks and takeovers also increase profitability as the profits are spread over fewer shares. Increased profitability means higher earnings yields, and a bigger gap (good news).
If all investors recognised that shares are undervalued at this point then the gap would close very fast as buying pushed share prices up, but that would be good news as it just means investors get their gains faster. So the more worrying scenarios are a bear market in bonds (i.e. the end of cheap debt) and a collapse in earnings. These are, of course things I plan to investigate in more detail. But maybe this is indicative: Bill Gross, who manages the world’s largest bond fund, reportedly said on June 7 that the 10 year US Treasury Note will continue to fall and yields will peak at 6.5% (i.e 1% higher than now) in three to five years time.
Now I don’t know how accurate his predictions are, but that doesn’t sound like an acceleration considering it would take a 2% move (in bonds alone) to close the gap. And not everyone’s that bearish. Also, remember the figures I use come from Fisher Investments and it is talking about global bond yields, not US only.
On the crude assumption that the gap will close at the rate it has since the end of last year, that puts parity sometime in mid-late 2008. So there doesn’t *seem* any reason to panic now. But that’s me, talking, not Ken Fisher. I don’t think he’d put that precise a date on it. I will post a more considered post - in time!
Hi Richard,
I hope that the interest rates do stabilise by next year. My five year fixed rate mortgage comes to and end in May 2008. Currently it is 4.3%. I am preparing for a lot of pain next year.
I was reading how the various banks, hedge funds and insurance companies have apparently not set enough aside to cover bad loans.
This annoys me because, as far as I am concerned, the reason they have not enough money is because they have paid themselves huge bonuses out of profits that they do not really own.
They know they are ultimately safe because, should the worst happen, their respective governments will bail them out.
Whether this is a fair or unfair assessment is largely irrelevant. It is what I believe and I imagine other people may feel the same.
Food for thought…
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