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What Drives the Market Risk Multiple? The Yield Curve


We're witnessing a tug of war between the Fed fighting deflationary pressure and the risk markets needing a flattening curve.

What's remarkable about these two adjustments is that ttheir fundamental calls have largely been correct. There has been no growth in personal consumption or corporate revenues. It's like BAML knew that it needed to make a change to get in line with the market, but since its fundamental thesis was still intact, the only option was to play on market technical factors. It's a wonder if BAML's retail clients understand that they are selling 10-years due to a MBS convexity blowout that has already blown out, or are buying a 1750 S&P price target due to multiple expansion that has already expanded.

I have never understood why equity valuation is measured against a risk-free Treasury. I prefer to measure equity relative value against the capital structure or the so-called risk curve. Both investors and corporations have a choice in whether they opt for equity or debt, and these instruments are priced very differently throughout the market cycle. I have charted the S&P earnings yield less the Moody's Baa 30-year bond yield index as a proxy for the market's risk curve and plotted it over the spread between 5-year/10-year as a proxy for the yield curve going back 40 years. This is the most important chart you will ever see. Why? The risk curve is on a 24-month lag.

With the yield curve still historically steep, equity risk remains very cheap when compared to credit risk, despite the rally in multiples. From a risk premium perspective, credit has outperformed equity.

As I wrote back in May as high yield was making record lows in The Low Spark of High-Yield Boys:

Between July 2011 and July 2012, inflation declined considerably with the PPI falling from 7.0% to nearly zero at 0.5% and the CPI falling from 3.4% to 1.4%. Over the same time, the yield curve as represented by the 5-year/10-year spread had flattened by over 50bps. As inflation pressure subsided, the inflation premiums in risk assets eased, and with that, risk premiums tightened. High yield has led the way with the High-yield CDX spread tightening from 700bps to 350bps; against equity risk, high yield outperformed from an even spread in June to over 200bps rich.

The casual market observer would look at the parabolic move in the S&P 500 and assume that stocks have led the rally in risk, and from a price-percentage-gain perspective, that they have outperformed high-yield bonds. However, from a risk premium/multiple perspective, high yield has massively outperformed stocks, suggesting the rally in stocks is actually a function of multiple expansion on the back of high-yield credit risk premium tightening. This revelation has important consequences going forward because of where credit sits at this stage in the cycle both on a relative basis and in outright yield.

The slope of the risk curve, i.e. multiple valuation, is a function of the yield curve, i.e. the inflation discount. The market's inflation discount drives the market multiple. This makes sense. Inflation expectations should impact the price you would be willing to pay for long-duration assets.

Of course, this means that QE -- to the extent that it is successful -- is not responsible for pushing up stock prices, but rather acts as a headwind. The multiple expansion we have seen since 2011 is ironically because QE has failed to stimulate inflation expectations. In fact, due to dollar strength, you could argue that the Bank of Japan has done more to support US equity prices than the Federal Reserve.

The market is not stupid. You can't inflate a multiple because the market only pays for real growth. For BAML to get further multiple expansion to support its 1750 price target, we are going to need to see inflation expectations come down and the yield curve flatten. That can happen either due to tightening Fed policy or a further deceleration in growth. Either way, we will need to see the curve flatten from the front (Fed tightening) or the back (decelerating growth).

When Bernanke delivered last week's Humphrey Hawkins testimony, he defended the Fed's price stability mandate.

[T]he Committee is certainly aware that very low inflation poses risks to economic performance -- for example, by raising the real cost of capital investment -- and increases the risk of outright deflation. Consequently, we will monitor this situation closely as well, and we will act as needed to ensure that inflation moves back toward our 2% objective over time.

Translation: The Fed will remain easy if inflation is too low.

In addition to raising its target for both the 10-year yield and the S&P price/multiple last week, BAML joined every other Wall Street firm and lowered its forecast for Q2 GDP. In nominal terms, it's looking like Q2 will print below 3.0%, which could be the lowest year-over-year growth rate of the recovery. When measuring against 2012's Q3 of 4.3%, Q4 of 3.5% and Q1of 3.3%, there is a clear trend of deceleration. Should this weak economic performance continue into the second half, it should exert downward pressure on long-term interest rates.

So we have this tug of war going on between the Fed fighting deflationary pressure and the risk markets needing a flattening curve to continue to support multiples. It's not clear who will win. One thing is clear. The recent steepening in the curve saw a very different reaction out of different investor classes. It seems that BAML's retail clients are taking BAML's advice, but the so-called smart money is not.

From BAML's report on client flow trends (emphasis my own):
Last week, during which the S&P rallied 3.0% to a new all-time-high of 1680, BAML clients were net sellers of US stocks after being net buyers the previous week. Net sales were $1.3bn, with outflows across the size spectrum. By client type, net sales were led by institutional clients, who have sold US stocks for the past four weeks. Hedge funds were also net sellers, following two weeks of net buying. Private clients were the sole net buyers, and this group has now bought stocks for seven consecutive weeks, beginning the week after the S&P peaked in late May.

I am not saying BAML is right or wrong in its analysis, but I find it curious that in this stage of the market cycle it has abandoned its fundamental discipline in favor of technical rationale in order to justify the change. The sophisticated investor understands this distinction, but I wonder if mom and pop investors do.

I'm also not saying risk can't continue to rally on the back of multiple expansion, but you have to understand what you are buying. At these levels, long-term savers are not buying growth; they are chasing multiple expansion, which has been bid up due to falling inflation expectations. That trade can continue, but it is subject to change. Ultimately, the risk curve is at the mercy of the yield curve.

Twitter: @exantefactor
No positions in stocks mentioned.
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