“International big business has made revolutions before now to safeguard its interests. At one time it made them … in the name of Liberty, Equality and Fraternity. Now, with Socialism to fight, it makes them in the name of Law and Order and Sound Finance. Assassination? If an assassination is going to be good for business, then there will be an assassination.” — Eric Ambler, The Mask of Dimitrios
Earnings Yield to 10-Year Treasury Yield
The ratio of S&P 500 earnings yield (earnings divided by price) to the 10-year Treasury yield, at the end of March, was at its highest level since 1949.
The year 1949 was a great time to invest in the stock market, as the market bottomed in June thereupon began one of the greatest bull markets in US history.
The US equity market was, however, trading at a trailing price-to-earnings multiple of 6.6x and 10-year treasury yields were 2.3 per cent. The challenge faced by long-term investors and asset allocators today is the S&P 500 is trading above 20x trailing earnings and long-terms yields are below 1 per cent.
Of course, as we have discussed in recent weeks, shifts in market structure make valuation metrics, relative or absolute, broadly speaking, unsuitable for temporal comparisons that stretch across multiple market regimes. Rather, valuation metrics are best used as an investment decision making tool when markets are mean-reverting. That is, valuations are most suitable for comparisons within individual market regimes but not across them.
The Lay of the Land
The Federal Reserve by announcing its decision to purchase exchange traded funds that buy high-yield debt, which sparked the biggest rally in junk bonds in more than a decade, has instituted a regime change.
The Fed’s balance sheet will begin to creep into lower and lower rungs of the corporate capital structure. Eventually crowding out private capital by outbidding on price first (i.e. lowering yields below the point of economic profit) and then by becoming the only game in town.
Private capital, other than that mandated or regulated (read: forced) to participate, will first exit the investment grade market and then the high yield market. The question then is, where will private capital be re-directed. The answer is probably more of the same: stocks, leveraged buyouts, growth equity and venture capital. For liquid market participants, occasional bouts of volatility notwithstanding, we may soon enter a phase where the adage of ‘there is no alternative’, or more colloquially TINA, once again becomes the reason to be long stocks.
Away from capital markets, the economic impact of the decisions made by the Fed and the US Treasury may prove to be even more weighty.
The Fed’s decision to, in effect, backstop the investment grade and junk bond markets will almost definitely entice the assumption of ever greater amounts of leverage by corporations — even though businesses as a whole are already over leveraged. Second, in an environment where the once financial truths of the time value of money and credit risk have been suspended, there will be further misallocation of capital away from productive activities to financial engineering. Lastly, with independent workers and smaller enterprises lacking the staying power and the captive legal expertise to navigate bail-out claims, the biggest benefactors of this crisis will be entrenched “big business”. This will, we think, further the sense of inequality as losses are once again socialised and profits remain the privilege of the very few.
We neither mean to pontificate nor to bemoan the realities. Our intention is to describe the lay of the land so that we be better placed to navigate markets.
COVID-19 Virulence
The above chart, in log scale, is of the aggregate confirmed cases of COVID-19 in the US, UK, Sweden, Brazil, India and New York State.
Obviously, we are not epidemiologists and do not want to pretend to be either. Some points are worth noting, however.
First, be it because testing for the virus is increasing linearly, social distancing measures are working or the COVID-19 is not as virulent as feared, the increase in confirmed cases is no longer increasing exponentially. Of particular note is the flatlining in New York State, hitherto the epicentre of the pandemic in the US.
Second, unless there is systematic underreporting of cases, the trajectory of confirmed cases in Sweden, which has not enacted social distancing measures, suggests that the widespread ‘closure’ of economies may not have been necessary.
Lastly, presupposing no systematic underreporting, the virulence of COVID-19 is proving to be lower in the warmer climes of Brazil and India. If so, as we head into the summer months, there remains hope of a sharp drop off in the spread of the virus. That being said, this also raises the prospect of another wave of cases come the winter.
Ignoring for the moment the potential revival in the winter, if the summer months bring reprieve and confirmed cases peak globally during April, the probability of the S&P 500 re-testing the year-to-date lows is likely to be much lower than anticipated by most. Moreover, with plenty of cash on the side lines, the path of least resistance for stocks may be higher, much higher.
Two Charts
We end this week’s piece with two charts.
Chinese ADRs Outperformance
The above chart compares the price performance of a select few Chinese ADRs trading in the US versus that of the S&P 500 Index and the NASDAQ 100 Index. The Chinese ADRs, we highlight, have significantly outperformed the broader indices and even many of the leading big tech stocks. The only big tech name with comparable performance to most of these ADRs is that of Amazon.
This warrants further digging into Chinese tech plays at some point soon.
Gold-to-Oil Ratio
The below chart is of the gold-to-oil ratio, using Brent crude spot prices. (The dashed lines are the one and two standard deviation points above and below the average of the ratio, which is shown with the black line.)
The fortunes of the two commodities could not be starker. This chart is not so different from the earnings yield to treasury yield chart at the start of the piece.
We are in truly unique times. There will come a time to be long oil, short gold.
Thank you for reading!
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.