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Shares Are Wildly Overpriced. But Bonds May Be Even Worse

Posted by hkarner - 14. Januar 2018

Date: 12-01-2018
Source: The Wall Street Journal

Stocks lose their appeal as yields rise; today’s high valuations suggest lower returns ahead

Bond yields are on the rise again, and it’s making shareholders jittery. They are right to worry, as low yields are the main support for historically high stock valuations, but bonds aren’t creating serious trouble for the equity market yet.

Bonds matter to shareholders in many ways, with the most obvious being that they are the main alternative investment, along with cash. Shares are very expensive compared with their own history on almost every measure, but compared with locking in a paltry 2.5% for 10 years they don’t look so bad. To put some numbers on it, analyst estimates of forward-looking operating earnings are 5.4% of the price of the S&P 500, and forecast to keep rising in future years. Why settle for 2.5% from bonds when the earnings yield on stocks is double that?

The question comes down to one of reward for risk. Earnings are uncertain, so shareholders should get an extra reward for the risk of holding stocks compared with the certainty offered by Treasurys. That reward, known as the equity risk premium, shrinks if bond yields rise faster than the outlook for profit.

Working out this equity risk premium is contentious, to put it mildly. The principle is to estimate how much companies will generate for shareholders in future and compare it with bonds, but there is little agreement on how to do that. We care about the future, and we want something long term, so typically the focus is on estimates for operating earnings, stripping out one-offs. Unfortunately, management know this, and artificially boost operating earnings via one-off losses—not just once, but year after year. Overall earnings also overstate how much investors benefit, as much corporate investment is wasted.Worse, we know that when investors are overly optimistic they overestimate earnings, making it look like the reward for holding equities is higher. Most methods of calculating the risk premium suggested equities in 2007 were the most attractive relative to bonds in at least a decade, shortly before shares crashed and bond prices soared.

Even the comparison to bonds is tricky; earnings have a loose connection to inflation so perhaps we should compare them with inflation-linked Treasurys, where the 10-year yield is just 0.5% above inflation.

Wall Street’s favored approach is to compare the earnings yield—12-month forward earnings as a proportion of the S&P—to the 10-year yield, which suggests U.S. shares have the lowest risk premium since January 2008. On this basis, investors need a lot more confidence than usual that economic and profit growth will continue to be strong—confidence that isn’t lacking at the moment.

Bullish investors may argue that the equity risk premium was a lot lower during optimistic periods in the past. It even turned negative during the dot-com bubble, when bond yields were much higher and investors preferred clicks to profit. Bulls can also point to soaring earnings last year, and the synchronized global recovery ought to boost global earnings further if it continues.

Meanwhile, bears worry that the U.S. economy is close to or at full capacity, crimping the prospect of low-inflation growth continuing, that companies are investing far too little to maintain the rate of earnings growth and that profit margins are unsustainable.

But even bulls ought to worry about the way that bond yields have been rising. Nominal yields have been rising since mid-December while real, inflation-linked, yields haven’t. That suggests the Treasury market expects higher inflation but no improvement to growth. So far the changes have been fairly small, but the direction suggests higher yields without an offsetting boost to the economy and profit. If it continues it would compress the equity risk premium further, reducing the appeal of shares compared with bonds.

A critical question, then, is whether bond yields will keep going up. Investors believe in a not-too-hot, not-too-cold Goldilocks economy, where inflation stays under control and the Federal Reserve ends its hikes at a lower level than in the past. If the narrative changes, bond yields could rise rapidly. Perhaps 2018 is the year inflation fears finally arrive.

Former Pimco “bond king” Bill Gross, now managing funds at Janus Henderson Investors, said this week that the break of a quarter-century downtrend in yields confirmed that bonds are in a bear market. Such technical analysis appeals to those who like lines on charts, but it is hard to believe that many investment decisions are based on a line drawn through five peaks on a chart since 1989, especially since it has been broken before (in 2007).

Perhaps the most powerful case for higher bond yields is that central banks are pulling away support. The Fed has begun to reduce its bondholdings, the European Central Bank has halved its purchases, and even the uber-dovish Bank of Japan has slowed the pace of bond buying as it targets prices more than quantities.

Forecasts of a sharp rise in bond yields have proven wrong year after year. However, continued low yields wouldn’t be a reason to think shares are great—just that they are better than bonds. High stock valuations tend to mean lower returns in the future, and valuations are very high compared with history.

Since 1900, U.S. stocks with dividends reinvested have returned 6% a year after inflation, according to Credit Suisse. Investors should be able to dampen down their expectations, and plan for something closer to 2% after inflation over the next decade as valuations drop back to more reasonable levels. That is still far better than bonds, just terribly disappointing for those who hope to repeat the 13% annualized real return of the past nine years’ bull run.


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