Credit Markets Signal Warning for a Relentless Equity Rally

(Bloomberg) -- US bond markets are signaling that equity bulls may be a little too exuberant now.

Stocks are close to the most overvalued against corporate credit and Treasuries in about two decades. The earnings yield on S&P 500 shares, the inverse of the price-earnings ratio, is at its lowest level compared with Treasury yields since 2002, signaling that equities are at their most expensive relative to fixed income in decades.

For company debt, the S&P 500’s earnings yield, at 3.7%, is close to the lowest relative to the 5.6% yield of BBB rated dollar corporate bonds since 2008.

The equity profit yield is usually above the BBB figure, because stocks are riskier. Since the turn of the century, when the gap between the two figures has been negative, as it is now, it tends to spell trouble for the stock market. Over that period, such a negative read has only ever occurred when the economy was experiencing a bubble or soaring credit risk, Bloomberg’s Ven Ram wrote last month.

“When you look at BBB yields, and any of the other benchmark ones — the 10-year, the 2-year — there’s a very significant gap between them and equity profit yields,” said Brad McMillan, chief investment officer at Commonwealth Financial Network. “Historically that’s often preceded a pretty significant drawdown.”

A correction isn’t necessarily coming in the near term: the spread between the S&P’s profit yield and BBBs has been negative for about two years, and the difference can persist for long periods of time.

But the current relationship between earnings and bond yields is yet another worrying sign of just how expensive shares are, and how fragile the post-US election rally in the stock market really is. Morgan Stanley strategists including Michael Wilson cautioned on Monday that higher yields and a strong dollar could weigh on equity valuations and corporate profits, hitting equities.

Investors got a sense of the risk when the Federal Reserve said on Dec. 18 that it was planning to cut rates at a slower pace than previously expected. Fears that the Fed was keeping rates higher for longer than the market previously expected helped push US stocks down nearly 3% that day, their worst Fed day since 2001, although shares have since clawed back much of that loss.

Even with a potential correction brewing at some point, investors are content to take the risk for now, said Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors – whether that’s pouring into equities at sky-high prices or putting money into crypto. Equities are trading at about 27 times their earnings for the last 12 months, compared with an average of about 18.7 times for the last two decades.