Two narratives we’ve been keen on exploring over the past several months are, i) the extent to which buybacks are responsible for persistent strength in US equities, and ii) how much of the bid for US Treasurys can be explained by negative rate policies in Japan and Europe.
These are key considerations, especially if we want to try and understand this rather glaring discrepancy:
As we’ve seen, valuations are stretched for both stocks and bonds. Just how rich is the S&P, you ask? Here’s a snapshot:
(Table: Goldman)
Note the blue shaded column. There’s not too much to like about that in terms of bargain hunting.
So what about Treasurys? We can clearly see that yields are plumbing all-time lows, but can get some context? Yes, we can:
(Chart: SocGen)
For brevity’s sake, we won’t go into the specifics, but what that essentially shows is that even if you strip out the effects of the global low yield environment, 10s are still two standard deviations too expensive. That may account for this week’s abysmal 10Y auction.
It’s against that backdrop that Citi is out with a look at “the big three (and one more)” questions. Here they are:
“Three questions tend to be uppermost in their minds – can ‘defensives’ keep rallying, how can investors be ‘bearish’ if the S&P 500 touches record levels and what if Trump wins? In addition, is there a possibility of even higher P/E ratios if US bond yields are suppressed by negative yields elsewhere?”
Here’s what the bank has to say about sentiment:
“Another issue that is frequently brought up in meetings is how we can suggest that sentiment is poor with new highs being achieved? Panic/Euphoria in “panic” (see Figure 5), money flows, and intra-stock correlation at near 87% (illustrated in Figure 6) clearly suggest that many investors remain cautious.”
(Charts: Citi)
The second chart there is particularly important. It depicts the extent to which inflow is dominated by buybacks (dark blue bars), not mutual funds and equity ETFs (light blue bars). In other words, this is artificial demand. And don’t forget, that demand comes with a balance sheet price:
(Chart: Goldman)
Getting back to Citi, here’s what they have to say about Trump:
“The Brexit vote outcome has shattered illusions about what to expect as the rise of populist voices has been heard and thus investment professionals have newfound acknowledgement (if not respect) for the rising tide of nationalism/protectionism of the middle class. Most worry that a Trump presidency could sow greater uncertainty and thereby an economic stalling out as business leaders hold off making decisions until they get a better feel for the Trump administration’s plans.”
There’s even a mention of the possibility that Trump would bring helicopter money to America by embarking on a “fiscal spending spree.”
As for whether inexorably lower yields on bonds facilitated by negative rates policies in Europe and Japan will continue to push money into equities and thus drive multiples even higher (remember, S&P earnings are falling), Citi begrudgingly admits that’s a distinct possibility:
“We are uncomfortable pushing for elevated valuations as the reason to buy stocks, but both our normalized earnings yield gap analysis and Panic/Euphoria Model would support double-digit gains in the next year when our current mid-year 2017 target for the S&P 500 is only 5% above current levels and the market is a mere 1% away from our year-end 2016 objective.”
In other words: “hold your nose and buy.”
Trade accordingly.
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