Weekly Charts
Each Thursday, the MCP Research team will share two charts we’re currently looking at that bring insights into the current state of the markets. This week—equity spreads.
If you’ve followed our content over the past few years, you’ll know that equity spreads are the cornerstone to how we interpret the relative attractiveness of equity prices. They help to quantify the risk-reward payoff in the stock market at any given time. One spread we look at in particular is the difference between the forward earnings yield on the S&P500 (EPS/Share Price) less the yield on the US10Y Treasury Bond (Figure 1). The idea is, the current 4.4% earnings return in the stock market is attractive if the alternative is a guaranteed 1.6% return on a treasury bond. Because stocks involve volatility and bankruptcy risks, the wider the spread the better the risk-reward payoff, and the tighter the spread the worse the risk-reward. All else equal, investors should buy when spreads are wide and sell when spreads are tight (Figure 2).
The current 280bps spread is an interesting level. The market had tested this level multiple times in 2017 and 2018 but wasn’t able to go lower due to a trade war and a hawkish Fed. Today’s environment is different. We are set to enter a synchronized global economic recovery and the Federal Reserve has a new “do whatever it takes” attitude to improving employment, spurring inflation, and printing money. Rightly or wrongly, investors will be forced further out on the risk curve, and spread contraction will be inevitable. In the short term, watch for resistance. This is a key level, and the prospect of higher corporate tax rates, mass expiration of IPO/SPAC lock-up periods, and the tapering of Q3 earnings growth will make spreads seem tight.
It’s interesting to note the excessive level of exuberance during the dot-com boom that took spreads into negative territory. In March 2000, the stock market’s earnings yield was 3.8%, while Treasury bonds yielded 6.2%.
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