The S&P500 rose another 0.8% last week in what looked like a resumption of the “Trump trade” that is betting on lower corporate income taxes to boost corporate profits and overall economic growth in the near future. Whether any of Trump’s market-boosting proposals actually get implemented is far from certain, but the US stock market doesn’t care; it is starting to price all this in as a certainty. In the meantime, since sales and overall profits are not yet rising, valuations are getting even more stretched. For the S&P500, price-to-sales and price-to-10 year earnings (Shiller PE) are at levels seen only once or twice over the past 100 years!
In US economic news last week, the results were mostly week. One exception was initial jobless claims, which hit another multi-decade low. The problem with reading too much more positive news into this reading is that history suggests that once claims fall to current levels, they don’t fall much further; in fact, from these super-low levels, they usually begin to climb. The other reports were weak. Gallop’s measure of US consumer spending plunged. Job openings, as measured by t he JOLTS employment survey, fell. Consumer credit missed expectations by a lot. Import prices jumped; this hurts corporate profits. Meanwhile export prices barely budged. Consumer credit also missed.
Since almost all broad and well-established measures of US stock market valuation clearly show that prices are on the high side of average, an investor looking for value could naturally ask about the other major corporate security available to buy—corporate bonds. Specifically, how do the prices of investment grade and high yield bonds look?
One important measure to assess is the yield spread between corporate bonds and comparable (in terms of maturity) US Treasuries. When the spread is large (ie. the corporate bonds pay a lot more than the comparable Treasuries) then the corporate bonds are priced lower….in other words, more attractively. When the spread is small, then the corporate bonds are priced high.
Today, the spread between Treasuries and high yield corporate bonds is as low as it’s been since before the Great Recession began. In other words, high yield bonds are not cheap; arguably, they are expensive and offer little value.
For investment grade corporate bonds (say BBB rated paper), the same is true—spreads are lower than they’ve been since late 2014 and the period before the Great Recession began (2004-2007). So investment grade corporate bonds are also not cheap; arguably, they’re expensive.
Once again, this makes life difficult for anyone trying to build a value-oriented portfolio. Not only are most US stocks very expensive, but so are most US corporate bonds. And given that stocks and bonds make up the bulk of any large investment portfolio—at least they ought to—this means that when the next market correction hits, even a well diversified portfolio will get hurt more than it might otherwise, since both corporate bonds and equities will most likely retreat in valuation.