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Relative Valuations Between Equities, Bonds, and Cash (Feb 2019 Update)

Equities have higher expected returns than most forms of bonds. This is because most bonds have a set maturity date, but the income stream from equities are potentially perpetual. Therefore, the risk and volatility associated with equity cash flows will be structurally higher.

This is true until you get to either the lowest end of B-rated credit or the top end of C-rated credit because the companies are in poor financial shape. Therefore, the additional credit risk outweighs the risk/volatility contribution from the longer duration of equities.

Accordingly, we know that equities must return above bonds, and bonds must return above cash by the appropriate risk premiums. And we can then determine how these track against each other to determine relative valuations. This can then be used to help make better decisions over how to allocate capital.

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Examples

Let’s use cash versus equities. Historically cash (e.g., taken to be a 3-month US Treasury bill) has returned an extra 582bps over equities.

We should expect this to remain relatively constant over time because investors will naturally be inclined to arbitrage the difference. They’ll generally be inclined to move capital to wherever they can get the most return for the least risk.

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1. So let’s say you do your discounted cash flow math on equities and come up with future expected returns on stocks of 5.5%, but the return on cash is 0.0% (these are made up numbers).

You would look at this and think that based on where you’d expect the premium to be, equities are expensive. But on the same token, cash doesn’t yield anything.

So buying cash doesn’t make sense unless you can either:

(a) borrow at a sufficiently negative rate in another asset denominated in that currency (highly unlikely) to generate a profitable spread or,

(b) borrow at an adequately negative rate in another asset denominated in a foreign currency to generate a profitable spread AND hedge out that currency risk such that it doesn’t damage the risk or yield characteristics of the trade.

For that reason, even though the relative valuation of equities is bad, you might choose to allocate to stocks because there is no other viable alternative.

Or, you could observe that even though the relative valuation of stocks is low, that doesn’t make for a very compelling reason to invest in stocks and not bother with either from both a relative and absolute valuation standpoint.

Of course, this criteria is overly simplistic. But looking at the risk premia among asset classes and asset tiers is one way of thinking about how to judge value.

Investing based on perceptions of value is probably not a good idea because it doesn’t get at the fundamental driver of what moves markets. It doesn’t shed insight into direction but rather helps to determine risk levels.

2. Stocks yield 6%, cash yields 1% (again, made up numbers for the sake of example).

The risk premium for equities is even worse at 5% (6% minus the 1% cash rate), but cash yields only 1%.

However, the spread, rather than the nominal return taken at face value, is really what matters most. If you have the capability to borrow in a cheap currency and hedge out that risk, the return on that cash, relative to the collateral amount required to put on the entire structure of the trade, could still be quite good – even with the cash yield being that “bad” (i.e., north of 20% annually) so long as a different form of funding is available to capture that spread.

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Relative Valuations

The chart below compares the relative valuation of US equities versus cash, US 10-years, and various quality tiers of corporate credit. 

(Click to enlarge)

This shows that equities are expensive relative to cash, 10-year Treasuries, and most forms of credit.

This means that, for example, historically stocks give you 407bps of extra annual yield over the 10-year, but are currently only giving you 345bps.

However, using historical numbers can be flawed for a few reasons:

1. The returns and risks of asset classes can be structurally different than they were in the past.

2. Since credit ratings are done by a credit agencies, you’re relying on their judgments. Generally, they use fairly mechanical criteria and apply it to past financial information to come up with a rating. Moreover, they are often slow to change ratings even when material information is already known. If the criteria that go into these ratings change over time and credit agencies don’t do an appropriate job of accurately gauging the risks of the companies they evaluate, it will produce a flawed metric.

3. If you’re trying to use the past to inform the future and the future is different from the past, then that can be an issue.

Trading strategies that are formed along the thinking of, “whenever X has gotten to price Y historically, it hasn’t gone below or it usually doesn’t go below, so therefore it’s a good buy” or “whenever X gets up to an average of the prices of the past Y number of days/weeks/periods, then it’s good time to sell it” can be naïve and dangerous. 

It doesn’t get at the drivers of what actually makes the asset move. Extrapolating the past without knowing what causes the asset to move in the way that it does by paying no recourse to the economics or how sustainable the set of conditions might be is a dangerous path.

With that said, it can give an idea of what to expect and defaults track closely to credit quality over time on a broad level.

What the actual true “fair value” or “fair yields” of those debts depends on your pro forma calculations of the discounted cash flow on a fundamental level.

On a technical level, who are the buyers, who are the sellers (e.g., central banks, commercial banks, pensions, private institutions, etc.), and what are their motivations and ability to absorb these assets based on their balance sheets.

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Conclusion

Looking at the yields between cash, bonds, and stocks is important because it paints a picture of the discounted future. Later on in the cycle, spreads tend to get too low because people are overly optimistic about the future and assets become fully priced or overly priced and you would need to think about how to deal with that.

How do you determine how to think about the future?

1. What are the unemployment rates? Low unemployment rates regularly go hand in hand with low credit spreads. It shows that the capacity to squeeze more out of the current cycle is limited.

2. What is the central bank doing? Even if prices are relatively high, it doesn’t mean it’s necessarily a good time to sell. Are the central banks easing policy? Are they lowering rates, are they buying assets? If central banks provide sufficient liquidity, that’ll go into assets.

Even in highly indebted societies, if their debt is denominated in domestic currency, they can lower the rates and buy the debt. Instead of the costs being reflected in the sovereign credit through higher yields, it is diverted into the currency channel (depreciates).

3. How is debt tracking relative to earnings and output? Even if debt is rising faster than earnings, that doesn’t mean imminent trouble because it depends on the servicing. But it’s not a sustainable set of conditions when that’s occurring and eventually balance sheets become topped out. 

4. What’s the level of sentiment? That means how are other investors positioned.

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Ways to gauge sentiment:

a) What’s the speculative positioning in various markets? You can often find this data for free through the CFTC on long/short positioning.

b) Various investment banks publish both soft and hard metrics. Survey-based measures generally take the pulse of what their brokerage clients are currently doing.

Other metrics include equity allocation as a percentage, cash allocation, the beta of clients’ top equity holdings, and proprietary bull/bear indicators.

Markets classically top or bottom when there are no new buyers or sellers at the margin. Therefore, when a market is stretched long or short, there is risk is going with that consensus the larger it is. We saw in oil last year when bullish bets were at a record high with WTI crude in the $70s. We saw this in gold and Treasuries with large short positions. They best act as contrarian indicators.

5. How much growth is expected going forward is baked into asset prices. Lower credit spreads mean higher bond prices, which means higher expected growth. The same is true for equities. Using discounted cash flow, you can back this out and compare it relative to what’s realistic. 

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