Click here to subscribe to updates to Investment Postcards from Cape Town by e-mail
The S&P 500 Index is anticipating too much too soon. Robert Shiller’s PE10 based on 10-year trailing earnings is currently at 22.85 compared to lows of 18.91 in August and 19.37 in November last year. While the PE10 is still at reasonable levels compared to the state of the underlying economy as measured by the Conference Board Consumer Confidence Index, some clouds are appearing on the horizon.
U.S. long-term bond yields have jumped in recent weeks and there is ample scope for further significant rises at the long end of the curve. In previous articles I alluded to the fact that the long end of the bond market was out of sync with the underlying economic fundamentals as a result of the Fed’s Twist program. The chickens are coming home to roost as the catch-up with the economy is under way. To normalize, the yield of the 10-year government bond has to rise by another 100 basis points from the current 2.39%.
Rising bond yields are not a real threat to the stock market, though, as the trend of the bond yield is normally an excellent indicator of the outlook for the underlying economy. Some divergence between bond yields and the valuation of the S&P 500 Index occurred in the second half of last year but it can be ascribed to the Fed’s buy-back of long-dated bonds in Operation Twist. The action per se resulted in the valuation levels not dropping off too sharply.
Sources: Robert Shiller; FRED; I-Net; Plexus Holdings.
But what is the threat to the stock market, you may ask. The answer lies in mortgage rates. Over the past few weeks mortgage rates have remained virtually unchanged in the face of a major about-turn of approximately 50 basis points at the long end of the bond market. The gap between the 30-year fixed mortgage rate and the yield on the 30-year government note has closed to approximately 47 basis points.
Sources: FRED; I-Net; Plexus Holdings.
It therefore seems to me that banks and financial institutions are more willing to accept higher risk in their lending. That explains why there is a relationship between Robert Shiller’s PE10 and the gap between the fixed mortgage rate and the bond yield (please note the reverse axis). It can be argued that the closing of the gap is bullish for stocks but it has to be watched very closely as the gap in fact leads the valuation levels of the S&P 500 Index at major turning points. In 2005 the gap diverged from the PE10 until the PE10 eventually followed when the market crashed in 2008. At the end of 2008 the gap closed rapidly but the stock market’s valuation continued lower until it bottomed two months later.
Sources: Robert Shiller; FRED; I-Net; Plexus Holdings.
The stock market has led the gap between the mortgage rate and bond yield since September last year and the gap has caught up with the stock market valuation in recent weeks.
Sources: Robert Shiller; FRED; I-Net; Plexus Holdings.
My concern is that all indications are that the stock market (S&P 500) is currently priced for perfection compared to the underlying economy and the gap between mortgage rates and yields at the long end of the yield curve. Yes, I still see a PE10 of 25 by the end of this year but the market has reached levels where it is highly susceptible to any global economic setback. We still have to find our way through minefields in the market place this year. How will the impact of the austerity measures in the Eurozone affect the global economy? Will China be able to shrug off the weak global economy? Will the U.S. be able to build further on the fragile economic recovery? Where is the oil price heading? Will Iran’s aggression result in an all-out war? The bottom line is that the stock market is no longer cheap. Yes, it can go higher and clock 25 or more on Robert Shiller’s PE10 scale but that would be bordering on irrational market behavior. It seems to me that more investors share my view as the inverse of the PE10 or EY10 (trailing 10-year earnings yield) has not followed through on the further drop in the VIX to 15.
Sources: Robert Shiller; CBOE; Plexus Holdings.
The above analysis argues in favor of increasing positions in non-cyclical stocks at the cost of cyclical stocks as I believe that is where opportunities will present themselves in coming months.
