Like Gonzaga in the NCAA basketball tournament, stock market bulls are set for their first real test in a very long time.
High yield bonds returned a robust 15.4% in the year ending June 30, extending a winning streak that produced a 56.4% cumulative return since the end of 2015. After a quick, severe drawdown at the height of the COVID-19 scare, junk bonds have experienced nearly ideal market conditions, heralding a return to trends that have been in place for several years. The post-pandemic move toward this record low has been a boon to high yield bond investors, but it has also created a significant risk of reversal. We believe most things in the financial markets are defined by cycles, with Treasury yields and credit spreads no exception. Tight readings for both rate series demand that we consider the possibility that a cyclical reversal could weigh on junk bond prices going forward.
High yield corporate bonds returned over +15% for the twelve months ended June 30th, building on a strong five-year run that was interrupted by a short, but painful, drop at the onset of COVID-19. Chart 1 indicates that high yield bonds compound at a remarkably steady rate, with infrequent but severe drawdowns during times of financial stress.
For almost nine months, an historic Fed liquidity flood has washed away any economic, valuation, technical, or “sentimental” stock market challenges. Nonetheless, each economic disappointment brings hope this flood will intensify. Those hopes aren’t irrational, because when it comes to any measure of liquidity, rate of change is more important than level.
The first up-leg of the bull market has catapulted many Large Cap valuations to levels seen only in 1999, 2000, 2019, and pre-pandemic 2020. At the six-month point on September 23rd, the S&P 500 P/E on 5-Yr. Normalized EPS had already reached 26.9x—a reading that is 30% higher than at the same point of any other bull market.
We always do our own work and draw our own conclusions. Lately, though, we’ve wondered what the late “Monetary Marty” Zweig might say about the stock market’s current liquidity backdrop.
The 1999 leadership parallels we discussed in the latest Green Book remain intact—U.S. over foreign, Growth over Value, and Large over Small. Small Caps have given up most of the “beta bounce” enjoyed in the first two months off the December low, with one Small Cap measure—the Russell Microcap Index (the bottom 1000 of the Russell 2000)—undercutting last year’s relative strength low and those of 2011 and 2016.
Allow us to put forth yet another theory for this season’s plummet in NFL television ratings: Fed watching is back!
We think stock market action in the next few months will provide the Fed with an excuse to skip any rate increase in 2015. But our view is a minority one, and futures’ market odds on a September increase shot up in early August. Either way, the obsession over the timing of a Fed rate hike ignores the fact that world P/E ratios are already contracting—at least on the basis of our 5-Year Normalized EPS.