By The Curmudgeon
Having been steadfastly bearish since March of 1986, it is difficult for me to be sanguine about the stock market at this time. Especially, after Friday's sharp decline in the last two hours of trading. However, I do not think a bear market in equities can be sustained with Treasury note and bond yields this low.
An important valuation indicator compares the S&P 500 earnings yield with interest rates on the 10 year T note. (The earnings yield is the inverse of price/earnings ratio, so the current S&P 500 earnings yield of 5.94% based on the past 12 months’ earnings is equal to an average price/earnings ratio of 16.8 for the stocks in the Index.). The difference between these yields -at over 125 basis points- is currently very favorable for equities. All else being equal, a higher earnings yield and/or a lower bond/note yield should both help support stock prices. After all is said and done, stocks compete with bonds and notes for investors capital. So unless earnings collapse, the low Treasury yields will place a floor under equity prices. But are these low Treasury yields justified?
In late June, I was expecting the yield on the 10 year T note to be at least 5.5% (or even 5.75%) by now, but instead it has retreated from 5.22% to 4.68%. Rates on overseas sovereign bonds have also declined. It seems the entire move down in yields has been a "flight to quality" from bad credits and dropping stock prices.
Nonetheless, I think that "flight to quality" is completely misplaced and totally wrong headed. The credit quality of US government paper has sharply deteriorated due to our huge current account deficit and resulting indebtedness to the rest of the world. We maintain the US $ gives a much clearer picture of the health of the U.S. economy then Treasuries. And the $ has been in a long term decline since 2001. That decline has recently accelerated with all time lows against the Euro and 25 year lows against the GBP and Canadian $. So where is the quality in US Treasuries? If inflation accelerates or even holds steady, the real return on these securities will be negative (if it isn't already). I have been wrong for quite some time, but I still insist that yields must rise.
The buyers of 2 year T notes have been WRONG for the last 13 months, as they would have done better buying and rolling over short term T bills, commercial paper, and repos. The 2 year T note is now yielding 80 basis points less then Fed Funds. The note buyers expected the Fed to cut rates by now, but it has not happened yet and does not look likely to happen anytime soon. Yet the credit markets still expect the Fed to cut US interest rates by year-end judging from Fed Funds futures. Perhaps, because that's what the maestro (Greenspan) would have done. But Greenspan’s readiness to placate markets created asset bubbles, which we previously discussed in our article on Liquidity and Leverage.
It seems that there is an invisible hand that keep pushing yields down whenever there is a breakout in yields and sharp decline in the price of Treasuries. We believe that there are two main reasons why real yields on Treasuries are so low:
1. Mammoth US trade and current account deficits create huge foreign exchange build-ups in Asian Central banks (mostly China , but also Japan , S Korea, Taiwan , etc.). Most of this forex is in US $'s, because the U.S. is the world's largest debtor nation. To avoid a huge increase in the money supply and a further $ decline (by converting $s to the domestic currency), the imported $s are invested in U.S. Treasuries- directly by the central bank, private companies, or an intermediary.
2. As long as oil price stays high, OPEC countries and Russia will continue
to accumulate petro dollars. It used to be that when oil prices spiked
upwards, Treasuries would sell off. Now the opposite is the case- the two
markets seem to move together. This is largely due to the recycling of
petro-dollars into U.S. Treasuries. How long can this continue?
Of these two drivers, we believe the FX build- up by foreign central banks is more significant.
The FT recently reported that China's foreign exchange reserves had
reached $1.2 trillion and were 50% of their GDP. Their entire FX reserve
cache has occurred within the last 5 years! On May 23rd, Martin Wolfe
of the FT wrote, " By February of this year, the foreign currency reserves
of east and south Asian countries had reached $3,280bn, up by $2,490bn
since the beginning of 1999. China’s reserves alone reached $1,160bn, up
by $1,010bn over the same period. While a substantial accumulation of reserves
seemed a justified (if expensive) form of insurance in the aftermath of
the crisis, today’s levels look excessive."
Writing in the same FT edition, David Hale stated that China's foreign exchange reserves will reach $1.6 trillion by beginning of 2008! He further stated: "China intends to diversify out of its $1,200bn in foreign exchange reserves, currently held in government debt and bank certificates of deposit. It has carved out $200bn to invest in equities, corporate debt, hedge funds and private equity."
Conclusions: We think that if the foreign central banks diversify into equities and other non-fixed income investments, that Treasuries will no longer benefit from an artificial prop that probably has lowered the yield on the 10 year Note by at least 75 basis points. But until that happens, yields will stay quite low, which will put a floor under equity prices. In addition, the buyers of Treasuries are still expecting a Bernanke rate cut by year's end. We think that would be wrong, but his predecessor consistently bailed out equity markets despite his "irrational exuberance" comment in 1996. Hence, a "Bernanke put" may be factored into equity prices.
As long as real yields stay low, there will be incentive to buy stocks with growing earnings. This will temper any decline based on sub prime fallout or CLO/ private equity implosions. It would take a huge failure of a private equity firm to kick off a sustained bear market, in our opinion. As long as the credit markets are open for business, any stock market decline will likely be less then 10-12%. A major crash has been postponed for the time being.
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartrered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.