We are seeing the Dow and S&P 500 in record territory over the past week. Is there more room to run? It seems hard to make the case, especially given some of the economic stumbles over the last several months (such as the 0.1% Q1 GDP growth) and then the generally lack-luster earnings. For instance FactSet reported, “To date, 24 of the 30 companies in the DJIA have reported actual results. The blended earnings growth rate (combines actual results for companies that have reported and estimated results for companies yet to report) stands at -3.3%. If -3.3% is the final earning growth rate for the quarter, it will mark the third year-over-year decline in earnings in the past four quarters for the DJIA.”1 Time will tell if it was more than just “the weather,” but we are certainly skeptical that any sort of big economic upswing is on the horizon to drive valuations up further, as the signs continue to point to a lack of demand drivers. For instance, well past the weather issues, retail sales were only up 0.1% for April.
Furthermore there has been recent talk of overvaluations and even a stock “bubble.” For instance a recent article cited Shiller’s P/E ratio showing that valuations have only been this high in during the late 1920’s and prior to the 2007/2008 financial crisis.2 Does this very slow recovery that we are in the midst of, 5 years after the recession, justify well above average valuations?
While the headlines of record levels on the indexes make for a nice story, we actually haven’t seen the equity market do much over the first third of this year, even as we have seen a sizable decline in interest rates. One would think that the 40bps plus decline in rates on the 10-year Treasury would be supportive of an equity market rise, but the reality has been that the rate decline is on the back of weak economic data. Not to mention high energy and foods costs on the horizon that can impact consumer spending, to which about two-thirds of GDP is tied. Undoubtedly there will be some equity winners, depending on certain industries (for instance, we are favorable on certain subsectors of the energy industry), and we have seen M&A drive some moves of late, but broadly speaking, we feel that equities may have run their course.
Emerging markets or sovereign debt, is there an opportunity there? We saw the scare earlier this year with various emerging markets. Much of the developed world doesn’t offer rates any better than what we see here in the US…and fundamentally speaking, is Europe really looking better than the US? Even places like Italy and Spain, that have massive deficits and unemployment, are now a trading at yield of 3% and under.3
Not to mention the fact that we have seen some of the countries that have been forced to borrow from the IMF over the last several years now offering bonds at what we would see as pretty thin yields given the quality of the underlying country. For instance in April, Portugal was able to raise over €750 million at a mere rate of 3.575% and Greece was also able to raise €3 billion, in a deal that was well oversubscribed, at a yield of 4.75%. We certainly wouldn’t want to be tying up our money for years at yields under 4-5% in these still tenuous countries.
Turing to corporate credit, we are seeing investment grade bonds offer very little over Treasuries, with spreads over Treasuries at about 100bps and a YTW of 2.96%.4 We have voiced our concerns about this market over the years—the lack of covenant protection causing event risk (meaning a company can add a bunch of debt to the structure without being forced to take existing debt out—all the more of a concern as we are seeing M&A activity pick up), lower durations, and a positive correlation to Treasuries, meaning increased interest rate sensitivity (if you are in the camp that eventually interest rates will be increasing).
Looking the high yield market, there have been concerns that this market is no longer attractive given the yields currently offered. There is a good portion of the high yield market is at very thin yields, with the broad high yield index now reporting a yield to worst of 5.11%.5 However, we certainly don’t see that reflective of true opportunity in the high yield market. By the nature of an average number, you see lots below that level and we are also seeing lots above that level. If you break it down, there is a sizable portion of the market that is trading big premiums at or above call prices, leading to very low yields. As historically low interest rates persist and the refinancing machine cranks on, we don’t see that drag down on the index average yield to worst number easing anytime soon. However, underneath that low headline yield is a good portion of the high yield bond and leverage loan market where we are seeing what we would consider as attractive yields. Active players in the high yield space are able to focus their efforts on this area of the market, where there is seemingly attractive yield to be had, rather than embracing the broader index/market as the passive players do, and forced to take the low yields offered.
So looking at the investment horizon before us, we continue to see certain portions of the high yield bond and bank loan market that can be accessed and parsed out via active management as still offering an attractive opportunity in today’s low yield and high equity valuation world.
1 Butters, John, “Earnings Insight,” FactSet, May 2, 2014, p. 2.
2Shiller P/E as of 5/16/14, http://www.multpl.com/shiller-pe/.
3 Data sourced from Bloomberg, as of 5/6/14.
4 Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital), data as of 5/14/14.
5 The Bank of America Merrill Lynch High Yield Index, which monitors the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. Index data sourced from Bloomberg, yield to worst as of 5/14/14.