Originally sent to clients on August 25, 2010
We are bullish on US stocks, and have been slowly increasing our allocation to stocks during the pullback started in May. Our view is that while US and global growth may moderate, it is not turning outright negative. Many economists and investors are predicting a “double-dip” in which our economy re-enters a period of negative GDP growth. The factors cited for such a phenomenon are unemployment, looming tax increases, and weakening consumer confidence. While these factors are certainly causes for concern, they are secondary indicators. This means that they influence the future, but do not predict it with certainty. In the end, the stock market has, and always will be, about valuation.
While secondary indicators such as unemployment and likely tax increases could decrease earnings in the future, this possibility has not been reflected in corporate earnings reports. Corporate earnings in the US continue to surge, as indicated by 75% of companies in the S&P 500 beating earnings estimates. Additionally, second quarter S&P 500 earnings have increased 28.6% over the same period a year ago. Companies have cut costs (namely employment) extremely effectively, causing earnings to skyrocket while revenues have increased more modestly. US companies are running leaner than ever, and are earning substantial profits.
The recent fear about the future of the US economy has caused a significant dislocation between the government bond market and S&P 500 earnings. US government debt has been bid up to record-low yields while S&P 500 earnings continue to increase. To illustrate the dislocation, we prepared the following charts.
Overall Hypothesis: S&P 500 Earnings Yield and 10 Year Treasury Note Cannot Diverge Drastically
Our basic premise in reviewing this data is that the earnings yield on the S&P 500 and the yield on the 10 year US Treasury Note cannot diverge forever given a long enough time horizon. The reason for this is that the 10 year US Treasury Note is considered a “risk-free” asset. Because of its stature as an extremely safe haven, investors buy the 10 year note when they are scared, driving the yield on the note down (price and yields of bonds move inversely).
The earnings yield on stocks should be at a level somewhat higher than the 10 year note in order to justify the additional risk taken by investing in equities versus government bonds. This is because the 10 year note is considered the risk-free benchmark, so investors must be paid a certain “risk premium” on top of this yield in order to be enticed to take on risk. US mortgage rates, corporate bond yields, and all other fixed income products move with the 10 year note.
By lowering government bond yields, investors are forced to take on risk. This is because institutional investors require a certain level of yield to satisfy unfunded liabilities. Specifically, pension funds must fund upcoming retirements, endowments must fund ongoing capital expenditures, and so on and so forth. Once the yield on government bonds becomes too low, these institutional investors are forced back into higher yielding (i.e. higher risk) investments, such as corporate bonds, stocks, and commodities.
This concept motivated the Federal Reserve to take the aggressive step of buying US Treasury bonds in early 2009 in order to keep yields on government debt artificially low. This move helped fuel the incredible rally in stocks of 82.56% from March 2009 to April 2010. The Federal Reserve recently decided to continue this course of policy indefinitely.
Chart 1: Ratio of 10 Year Treasury Note Divided by S&P 500 Earnings Yield
This chart shows the ratio of the yield on the 10 Year US Treasury Note vs. the earnings yield on the S&P 500.
The box on the right entitled “Ratio Summary” gives us statistics about this ratio over the past 48 years of market history. The highest this ratio has ever been was 2.1852, and this occurred on 10/9/1987. The lowest this ratio has ever been was 0.2584 and occurred on 12/26/2008. The reason this ratio does not deviate wildly is because of the relationship I highlighted above between risk assets (i.e. stocks, corporate bonds, commodities, etc.) and riskless assets (US government bonds).
Hypothesis: High 10 Year Note Yield to S&P 500 Earnings Yield Ratio Is Bearish For Stocks
According to my hypothesis, the three obvious peaks in this chart (as denoted by the red arrows) should be signaling investors to be wary of the stock market. These three peaks occur around a ratio of 2, meaning that the yield on government bonds is twice as high as the earnings yield of the S&P 500. This is an alarming scenario, because it indicates that investors are willing to pay an incredibly high amount for risk assets, when riskless assets are actually yielding twice as much.
Analysis: Data Confirms Abnormally High Ratio Signals Bear Market for Stocks
The first peak in the chart is especially alarming. This peak occurred literally 1 week before the infamous “Black Monday” in 1987. On Black Monday, stocks lost over 20% of their value in a single day! The second peak occurred in January of 1992, and a period of flat performance for 6 months thereafter was witnessed, followed by a continuation of the previous rally. The third peak occurred in January of 2000 during the froth of the technology stock bubble. Stocks peaked in March of 2000, and then lost over 50% of their value during the next 3 years.
This data regarding the relationship between yields indicates investors should be extremely cautious when observing that the stock market’s earnings yield is significantly less than the 10 year note. Let us turn our attention to other end of the spectrum, when the stock market’s earnings yield is far above the 10 year note.
Hypothesis: Low 10 Year Note Yield to S&P 500 Earnings Yield Ratio Is Bullish For Stocks
Since the ratio approaching 2 was a significant event for bears, it follows that the ratio approaching 0.5 could be important for bulls (meaning the earnings yield is twice the 10 year note yield).
Analysis: Data Confirms Abnormally Low Ratio Signals Bull Market for Stocks
The ratio’s approach to 0.5 seems to be a strong bullish indicator. The first valley on this chart occurred in December of 1974 when the ratio was at 0.545. In the year thereafter, stocks returned 37.58%. Pushing one more year out to measure performance between December 1974 and December 1976, stocks returned a blistering 63.81%. The ratio did not approach this low a level again until December of 2008. Three months thereafter, stocks went on an unprecedented bull market tear, returning 82.56% from March 2009 until April 2010.
The hypothesis holds true, with the caveat that the investor must be willing to be on the early side of the trade. This ratio tends to be a leading indicator, meaning that it could take some time for the market to recognize this dislocation. This characteristic makes sense, as it takes time for investors to digest this yield discrepancy and reallocate funds appropriately. During the most recent bull indicator, if an investor had bought stocks in December of 2008, a further -22% loss would have been experienced before witnessing the incredible rally.
Application of Hypothesis to Present Day: Outlook Bullish for US Stocks
The ratio is currently at 0.353, only the second time in history it has been below 0.5. The ratio is currently below the 1th percentile for the last 48 years of market observations, meaning this is an extremely low ratio historically. Given the stock market rallies witnessed when the ratio is below or near 0.5, increasing allocation to the S&P 500 seems appropriate.
Exhibit 2: Spread Between S&P 500 Earnings Yield and 10 Year US Treasury Note
To further illustrate the relationship, we have attached the following chart of the spread between the S&P 500 earnings yield and the 10 year note (this chart shows the S&P 500 earnings yield minus the yield on the 10 year note).
Hypothesis: Spread between S&P 500 Earnings Yield and 10 Year Note Yield Exceeding 4.0% Is Bullish for Stocks
This phenomenon should be bullish for stocks because low yields on government bonds should push investors back into riskier assets. The white band indicates that the earnings yield on the S&P 500 exceeded the 10 year note yield by more than 4.0% (as can be seen from the graph, a historically unusual event).
Analysis: Data Confirms Spread Exceeding 4.0% Is Bullish For Stocks
Stocks performed extremely well directly after the spread exceeded 4.0%, triggering major bull markets for stocks 4 out of 5 times. In the instance a major bull market was not triggered, stocks did not fall below the support level established when the spread exceeded 4.0%.
The first instance of the spread exceeding 4.0% occurred in October of 1974. The S&P 500 achieved a major bottom that month at around the 70 level. This level on the S&P 500 was never seen again. The second instance occurred in March of 1978. This marked the exact end of a one year correction after the major bull run started in October 1974. This level was also never seen again. The next instance occurred in July 1979, during an ongoing bull market. This level proved to be major support for the index, as it was challenged numerous times over the course of the next 5 years, and never broke it. The fourth instance occurred in April 1980, coincidentally at the same level on the S&P as the previous instance. This instance set up a major bull market that lasted for the next seven years and would produce an astonishing 300% return during that time span. Again, this level on the S&P was never seen again.
The next two instances of this phenomenon happened during our most recent financial crisis. The spread first exceeded 4.0% in October of 2008. However, as can be seen from the chart, the spread remained far above 4.0% until April of 2009. The same caveat of being early to register a buy signal that applied to the ratio appears to apply to the spread as well. The last instance of the spread exceeding 4.0% happened on July 2, 2010
Application of Hypothesis to Present Day: Outlook Bullish for US Stocks
The spread currently stands at 4.60%, only the 6th time this has occurred in the last 48 years. The current spread is in the 98th percentile of observations in the last 48 years.
The data seems to suggest that adding to an allocation in the stock market at these levels will be profitable as long as the investor can stomach possible short term pain. As witnessed in 2008-2009, these dislocations between the S&P 500 and US government debt can continue for months. However, if the investor can handle being early on the trade, the chances of success are very high.
Federal Reserve’s Actions to Artificially Hold Down Yields on US Government Debt
As mentioned above, the Federal Reserve enacted policy measures to purchase US government debt during the financial crisis. By keeping yields artificially low, the Federal Reserve hoped to encourage investment in riskier assets. The weight of their actions was felt during the ensuing 82.56% rally in stocks.
It is our belief that by keeping yields low, the Federal Reserve will again be successful in increasing appetite for risk assets. This aggressive policy measure had never been enacted before our most recent financial crisis, but its effects seem to be positive. The Federal Reserve recently declared their intention to continue this policy indefinitely, and it should only be a matter of time before investors shun the low yields of US government debt and move back into riskier assets such as stocks and commodities.
Recommended Strategy: Sell Out of the Money Put Options on Stock Indices
Given the uncertain nature of when this bull market will materialize, I recommend selling out of the money put options on stocks you would like to own, as well as selling put options on the major indices themselves (S&P 500 and Nasdaq 100). The fear currently present in the marketplace is indicated by the VIX (Volatility Index) being at a historically high level. What this means is that investors are willing to pay a high amount for put options to insure their portfolios.
Selling put options on the indices will profit from a market rally (as well as the passage of time), but will also not trigger losses until stocks fall to the strike price of the option. More aggressive investors will want to write put options closer to the current market price, 15% below current levels for example, whereas more conservative investors could write options for even 25-30% below current levels. A medium-term horizon should be used, with December of 2010 or January of 2011 as our preferred expiration dates.
As with any strategy or investment program, this course of action entails significant risk, and could result in losses of principal. Investors should consider their own risk tolerance and investment goals before undertaking this strategy.
ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.