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What Drives the Market Risk Multiple? The Yield Curve

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

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I am a big believer in the impact of sentiment on market dynamics. Over the past couple of weeks, we have seen some major capitulation among Wall Street strategists. Bank of America Merrill Lynch (NYSE:BAC), or BAML, has the largest network of retail financial advisors, and so when their strategists make a big forecast adjustment, it's worth noting as a gauge of potential retail investor sentiment.

After the better-than-expected June employment report, BAML rates strategist Priya Misra issued a revision to her interest rate forecast, raising the year-end 10-year target from 2.4% to 3.0%. On the surface, this target revision would not be that notable. But when I saw the headline, I immediately thought it was a capitulation.

Misra has been very bullish on bond prices predicated on slowing growth and consumption. Just back on May 13, with the 10-year approaching 2.0%, she reiterated her bullish view.

The recent sell-off has been puzzling since the only recent positive economic data of note was the April payroll report. Even though payrolls were better than expectations, it was not clear that we are out of the woods yet.... It is difficult to justify both higher real rates and lower inflation expectations than earlier this year from just a repricing of growth expectations.

Ultimately, fundamentals and Fed policy drive rates. Notwithstanding the payroll report, growth data in general has been a bit weak, in our view.... Thus, we recommend owning Treasuries, looking for the 10-year to drift back toward 1.75% in the next month.

Then, two weeks later, obviously burned by the intense mortgage-backed security (MBS) convexity blowout underway, she backed off from her bullish call and moved to 2.4%. Thus in reality, her target raise on July 5 wasn't from just 2.40% to 3.0%; she basically moved from 1.75% to 3.0% in less than two months, with no material change in fundamentals. In fact, you could certainly argue that her economic forecast has been spot on and that she just got caught by a carry trade blowup. Her rationale (emphasis my own):

The June FOMC meeting where the statement, projections, and the Chairman's press conference were hawkish relative to expectations, indicated a different Fed reaction function. The market perceives the Fed to have a lower threshold for tapering.

Labor market and housing data -- the most cited indicators from the Chairman's June FOMC press conference in June -- have continued to strengthen. Further, the outlook remains positive as downside risks have receded.

Apart from the fundamental shift above, technical factors continue to be key, and will be a headwind for the rates market. The new highs in rates should keep MBS convexity risks high. Given continued underperformance of bond fund indices, fund outflows should continue. This can continue to put pressure on Treasury rates as investors will look to hedge fixed income duration risks using Treasuries.

This past week, BAML's equity strategist Savita Subramanian followed up with a huge upgrade of her 2013 year-end S&P 500 (INDEXSP:.INX) target, moving from 1600 to 1750. This 150-handle change isn't just a calibration; she is changing the model (emphasis my own).

Our new S&P 500 target of 1750 for 2013 is principally based on our fair value model, but if the last several years have taught us anything, it is that fundamentals sometimes take a backseat to sentiment, technicals, and macro.

The equity rally over the last eight months has been primarily driven by multiple expansion, with the forward PE multiple on the S&P 500 expanding from 12x to 14x (18%). In our fair value model, we focus on the normalized forward PE multiple, which has also risen from 13.5x to 16.0x (18%). This multiple expansion has predominantly been a function of the significant decline in the equity risk premium (ERP), partially offset by a modest rise in real normalized interest rates. While current real normalized rates are only modestly higher than our previous year-end assumption of 1.0% (now forecasting 1.5%), the 135bp drop in the ERP is more than double the 50bp that we had originally assumed going into the year.

But at 500bp, the ERP is currently still well above the sub-400bp levels preceding the financial crisis, and we think it should continue to decline over the next several years as the memory of the financial crisis fades, corporate profits continue to make new highs, and some of the macro risks abate. We expect the "wall of worry" to persist as new concerns emerge, but visibility is clearly improving and we still expect global growth to pick up as the year progresses. As such, we have lowered our normalized risk premium assumption in our fair value model for the end of 2013 from 600bp to 475bp, which assumes roughly another 25bp of ERP contraction by year-end.

So with the market up 18% on the year on the back of 100% multiple expansion, BAML is raising its price target by nearly 10% on the premise that we shall get further multiple expansion because fundamentals have taken a backseat to technical and sentiment. You can't make this stuff up.

These two major price target revisions by the Street's biggest retail brokerage firm in the two most important asset classes within weeks of each other cannot be a coincidence. I think this capitulation reeks of a management shoulder tap. Research doesn't like to be on the wrong side of the market for too long because it screws up their track record. These two dramatic price target adjustments could be an attempt to get back in line with the market.

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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