Despite the latest inflation readings and possible rate increases in 2023 (Read more here), markets seems to stubbornly shake it off. This behaviour is clear in the US 10-year yield move and equity indices. After the FED meeting on June 16th, the yield spiked by 10 bps to 1.58%. However this has since reversed with the yield continuing its downtrend to 1.43%. Even though there was a fall from all time high of $4,260 the S&P500 still maintained its level above $4,000 impying investors are unwilling to unwind their positions to earn the much desired 2.23% earnings yield.
However as the price keeps encroaching upwards, this earnings yield will continue to shrink and will soon reach an all time low of 1.41% in 2009. Comparing the earnings yield with government yield gives a comparison on whether it is worth it to either hold risky stocks which hold a credit spread or safe bonds. At this stage, stocks outweigh the whole US term rates with the highest yield being the 20-year at 2.185%. Investors have continuously been slowly factoring in future economic growth and inflation this year with terms from 2Year to 30year having increased of 2bps to 60bps respectively. These moves seems meek when compared to the late inflation readings (Read more here)
Are stocks overvalued? An important measure of apparent valuation is the famed Shiller PE Ratio. This ratio divides the price of the S&P500 index by the inflation adjusted earnings of the historical 10 years. The graph below, provided by Longtermtrends.net shows the S&P500 being deep in overvalued territory and soon reaching the dot-com era valuations.
Another useful measure to assess long term valuations is the Market capitalization (captured by the Wilshire 5000) to Gross Domestic Product ratio. This ratio, created by Warren Buffett aims to measure whether stock valuations are in line with what the economy can output. And again as before, it shows incredible overvaluation to what the economy can produce. Buffet described this ratio as “probably the best single measure of where valuations stand at any given moment.”
Two important areas that had and are having great economic impact on markets are the Technology and Real estate sectors. Those two sectors have been behind the last two 21st century financial crisises. The former caused the Dot-Com Bubble and the latter primarily caused the Global Financial Crisis. It is vital to monitor them as uncertainties start creeping up this year and the next.
All time low yields, driven by central banks and governments wanting to shield the economy from an economic disaster pushed yield-starved investors to take more risk by either chasing capital gains through growth stocks (Mainly tech) or seek higher yields in the real estate sector (through REITs). This resulted in pushing credit spreads between Aaa and Baa corporate bonds to all time lows.
If the FED is getting a whiff of economic overheat, then they might take earlier action (earlier than 2023) to reign in inflation. Tapering and rate increases will severly impact sectors that benefited from this low-yield environment. As economies reopen, market participants are anticipating future economic growth and are therefore shifting to cyclical, lower volatility stocks. As the name implies, these stocks are cyclical and correlated positively to the performance of the economy. Should a shock to the economy is due (might happen if inflation gets out of hand), then even these stocks are at risk.
House prices have spiked recently as remote working increased demand for rural houses. Prices are close to the Housing Bubble levels when seen as a ratio of Price to Median Income.
Now the FED is stuck between a rock and a hard place with unpleasant, consequential decisions that would impact the global economy. A lot is at stake here and if the US do not figure how to keep things stable, we might even see a shift in the fundamental pillars in the global financial clogs. Central banks are doing their best at the moment by applying a wait and see approach and act only on reliable data.
For the individual investor, maybe it is time to deleverage, realize any profits gained and hold a cash position until new buying opportunies arrive in the near future.
image source : FT.com