One of the traditional responses to the recent bond rout is that at some point yields should become attractive enough to prompt a rotation out of stocks and back into bonds. A quick comparison between the 10Y Treasury yield and the yield on S&P dividends shows just how much more attractive bonds have become for yield starved investors.
And yet, asset allocation is a dynamic process, and as such there is probably no “magic” number which triggers a great un-rotation from stocks back into bonds. However, in an attempt to get an approximation of said number, Bank of America tested a few frameworks to determine the 10-yr yield breakpoint at which bonds look more attractive than stocks, and they all spit out the same number: 5%.
According to BofA’s Savita Subramanian, 5% is the level of the 10-yr Treasury bond yield at which Wall Street’s average allocations to stocks peaked, and then started to wane (as yields rise higher) according to the bank’s Sell Side Indicator.
5% is also the level of the 10-yr at which the market-derived equity risk premium framework indicates that stocks trade at fair value to bonds, all else equal (in other words, at current levels, stocks still appear inexpensive relative to bonds).
5% on the 10-yr is the level at which the reward to risk ratio for stocks vs. bonds skews more favorably toward bonds. Specifically, a 5% 10yr Treasury yield is the level at which the Information Ratio for stocks versus bonds has skewed more favorably toward bonds. (The information ratio is calculated as the median of the 12-month S&P 500 price returns divided by the standard deviation of returns within different yield periods using monthly forward 12-month data for returns.)
Most importantly, 5% is the expected return of the S&P 500 over the next decade, based on BofA’s valuation framework (which has explained 80%+ of stock returns in prior decades). According to Subramanian, based on an historical regression, using today’s price to normalized earnings ratio yields an expected annual price return of 5% for the S&P 500 over the next 10 years. If the 10yr Treasury, the so-called “risk-free” rate, climbs to the level of expected equity returns, the decision between stocks and bonds would be easy, as it becomes a question of “Risk-free” 5% vs. risky 5%.
Magic numbers aside, more conventional indicators such as the “Fed Model” are also cooling on stocks, and warming to bonds. The “Fed model” is a theory of equity valuation that compares the stock market’s earnings yield to the yield on long-term government bonds. The asset class offering a higher yield is deemed more attractive. After over 16 years of negative spreads between 10-year Treasury yields and S&P 500 earnings yield, the spread has narrowed as interest rates have increased, indicating that equities are losing their luster relative to bonds.
And while BofA tries to calm its clients by expecting the S&P 500 to continue to outperform bonds even as rates rise, it warns that “the road to higher rates is paved with potholes” namely, the presence of stock “land mines that have been created by free capital and rampant liquidity” including:
- “Short duration” bond proxies – high coupon paying stocks, which have been bid up for yield, but systematically underperform during periods of rising interest rates;
- “Long duration”, growthy credit sensitive stocks with no current earnings but a big future payout, which have thrived on cheap capital but are hurt by rising discount rates;
- Floating rate risk: companies that have not taken advantage of low rates to lock in fixed rate debt are at greater risk of refinancing pressure;
- Crowded equity income fund holdings, where these funds have garnered a disproportionate share of active assets as rates ground down to zero (equity income is now almost 50% of the actively managed pie vs. 20% just after the crisis). If flows move back into bond / balanced funds, these stocks could see considerable selling pressure;
- Small caps: not only are they longer duration and more credit sensitive than large caps, but they have more floating rate risk and are close to record leverage ratios.
But the biggest risk according to the BofA equity strategist from rising yields may be facing equity income funds, which have garnered a disproportionate share of active assets as rates ground down to zero. Equity income is now almost half of the actively managed pie (vs. less than 20% a few years ago). If income investors shift allocations back to traditional income offerings (bond and balanced funds), equity income AUM could come under considerable pressure, resulting in a substantial equity selloff.
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