U.S. Bond Market Signals Warning for Overvalued Stocks

Equity investors, better known as shareholders may be overlooking cautionary signals from U.S. bond markets, as stocks are now close to their most overvalued levels compared to corporate credit and Treasuries in nearly two decades.

The earnings yield on S&P 500 stocks—the inverse of the price-to-earnings ratio—is at its lowest point relative to Treasury yields since 2002, indicating equities are at their priciest compared to fixed income in decades.

For corporate debt, the S&P 500’s earnings yield stands at 3.7%, nearing the lowest level relative to the 5.6% yield of BBB-rated corporate bonds since 2008. Historically, equity profit yields typically exceed BBB yields due to the higher risk associated with stocks. When the gap turns negative, as it is now, it often signals trouble for the stock market. Bloomberg’s Ven Ram recently noted that such a negative spread has previously occurred only during periods of economic bubbles or heightened credit risk.

“When you compare BBB yields with other benchmarks like the 10-year or two-year Treasury yields, there’s a significant gap relative to equity profit yields,” said Brad McMillan, Chief Investment Officer at Commonwealth Equity Services LLC. “Historically, this has often preceded a significant market correction.”

No Immediate Correction, but Risks Loom

While a market correction may not be imminent, the spread between the S&P’s profit yield and BBB yields has been negative for nearly two years, showing that such disparities can persist for extended periods. However, the current disconnect between earnings and bond yields underscores concerns about the high valuation of equities and the fragility of the post-U.S. election rally in the stock market.

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Morgan Stanley strategists, including Michael Wilson, warned this week that rising yields and a strong dollar could pressure equity valuations and corporate profits. This was evident on December 18, when U.S. stocks fell nearly 3% after the Federal Reserve announced plans to slow its pace of interest rate cuts, marking the worst “Fed day” for stocks since 2001. While the market has since recovered much of that loss, the risks remain.

Dan Suzuki, Deputy Chief Investment Officer at Richard Bernstein Advisors LLC, observed that investors are still willing to take risks despite elevated valuations, as seen in the ongoing enthusiasm for equities and even cryptocurrencies. “People are leaning toward assets offering high upside potential,” Suzuki said. “You’re seeing more attempts to hit home runs.”

Valuations and Future Returns

Equities are currently trading at around 27 times their earnings for the past 12 months, far above the two-decade average of 18.7 times. The S&P 500 reached record highs 57 times in 2024, while initial coin offerings have also surged in popularity.

However, corporate bonds aren’t cheap either. Risk premiums on U.S. high-grade corporate bonds are just 0.81 percentage points above Treasury yields, close to their tightest levels in decades. “Both markets are pricing in significant optimism about corporate profits,” Suzuki noted.

Kevin Caron, Co-Chief Investment Officer at Washington Crossing Advisors LLC, pointed out that relying solely on spreads between earnings yields and corporate bond yields to predict downturns isn’t foolproof. “In the 1990s, it was common for the S&P’s yield to be below Baa corporate yields,” Caron explained. “That spread remained negative for an entire decade.”

Inflation and Equity Valuations

Comparing equity and bond yields, a practice known as the Fed model, provides insight into relative valuations but doesn’t account for inflation’s impact. While inflation reduces future fixed-income returns, its effect on equities is more complex.

Still, elevated equity valuations could make it challenging for prices to maintain their current pace of growth. Goldman Sachs recently predicted that the S&P 500’s annual returns would average just 3% over the next decade. Additionally, rising bond yields imply that equities need to deliver higher returns to stay competitive, potentially pushing stock prices lower.

“Bonds are less expensive than riskier assets like stocks,” said Michael O’Rourke, Chief Market Strategist at JonesTrading Group. “As Treasury yields climb, equity valuations will need to adjust downward to remain appealing.”

Report by Financial Post

January 9, 2025

977 3 minutes read

Lawrence Baraza

Lawrence Baraza is a dynamic journalist currently overseeing content at Metropol TV Digital. With a keen focus on business news and analytics, Lawrence guides the platform in delivering insightful, data-driven content that empowers its audience to make informed decisions. Lawrence’s commitment to quality and his ability to anticipate market trends make him a key figure in the digital media landscape. His work continues to shape the way business news is consumed, making a significant impact in the field.