In a recent article, I argued that "no taper" is not as big of a positive for bonds as many pundits seem to think. In this article, I will show that, for different reasons, "no taper" is not as big of a positive for stocks as many pundits seem to think.
Stocks Never Priced In Ultra-Low Yields
The most important thing investors need to understand is that stocks never fully priced in 10Y yields when they were at their all-time lows of around 1.6% in late 2012 and in May of 2013. In fact, stocks have never even come close to pricing in the current 10Y yield, which is at around 2.75%.
Interest-rate sensitive stock valuation models all imply stock prices that are dramatically higher than they are at present. For example, assuming a historically normal equity risk premium, normal dividend growth and the current 10Y bond yield, most dividend discount models would suggest a value of around 3000 for the S&P 500!
Better yet, given a 10Y Treasury yield of 2.75% and 12-month forward operating earnings estimate of $110 the S&P 500 should be trading at about 4000 right now according to the so-called Fed Model. That implies a Dow Jones Industrials Average at over 36,700. That would sure make Glassman and Hasset, the authors of the infamous book called Dow 36,000, proud!
But let's get our heads out of fantasy land and get back to planet earth.
Stock prices have never priced in ultra-low bond yields mainly because the market as a whole is efficient enough to reflect the fact that ultra-low bond yields are temporary and unsustainable. Furthermore, despite all of their inefficiencies, stock values are efficient enough to reflect the fact that in the unlikely event that bond yields were sustained at ultra-low levels, it would only be because of horribly deflationary conditions that would consequently cause forward EPS estimates to be reduced drastically.
Given that analysts are currently forecasting long-term earnings growth (i.e. they are not forecasting a deflationary collapse in EPS), it is evident that the equity market is effectively pricing in the expectation that 10Y Treasury yields are unsustainably low. This suggests that tapering and the normalization of long-term interest rates are already largely priced in to the value of stocks.
The Stock Market Sees Through Fed Tapering
The Fed will taper, QE will end, and interest rates will normalize; equity values reflect this general understanding.
Markets currently reflect the fact that ultra-low 10Y yields are temporary and unsustainable. And with good reason. First, current extraordinarily low yields are partly the result of unusual economic conditions that are unlikely to persist and are already well on the way to becoming normalized. Second, at this point, they are mainly the result of massive manipulation of interest rates by the Fed. Notwithstanding sluggish economic growth, the Fed has essentially had to "corner" the long-term treasury market, buying 49% of all Treasuries with maturities of between 10 and 15 years, in order to keep yields repressed at current levels. Current stock values price in a general understanding that this manipulation will come to and end and that long term interest rates will normalize and revert toward historical norms.
Therefore, the equity market is unlikely to get too affected by "tapering" and its effect on bond yields. Another way to express this is that stocks and bonds have become decoupled. Specifically, stocks seem to be ignoring 10Y yields (up or down), as long as those yields are perceived to be in an unsustainably low range.
In this context of temporarily low long-term bond yields, tapering should have relatively little impact on the valuation of stocks, and whatever impact there may be is ambiguous. The ambiguity results from the fact that tapering could be associated with either higher or lower stock prices. For example, in one scenario, "no taper" could trigger a stock rally if there were widespread expectations of rising liquidity due to infinite QE. In another scenario, the failure of the Fed to pull the trigger on tapering could signal deflationary conditions, which would be negative for stock values.
Equity Risk Premiums and Bond Risk Premiums
Many analysts have been arguing that the ERP (equity risk premium) is high. This claim has generally been made in support of the notion that stocks have a great deal of upside. I agree that stocks may have a great deal of upside, but the argument that the implied ERP is low is basically bogus.
Properly understood, equity risk premiums are not high at all; the risk free rate is artificially repressed, which is an entirely different matter.
First of all, correlative indicators of the implied ERP do not suggest that the equity risk premium is particularly high at this time. Indicators such as the level of the VIX, corporate bond spreads, sentiment surveys, or the spread between the PE ratios of value and growth stocks suggest, in fact, that the implied equity risk premium is in the normal to low range.
The theory that the ERP is currently high is simply a confusion that results from not understanding that it is not equity risk premiums that are currently high, it is bond risk premiums that are unusually low.
For example, with TIPS break-evens suggesting long term inflation expectations in the order of 2.3%, it is clear that the extraordinarily low 10Y bond yield of 2.75% (versus a more normal level nearer to of at least 4.5%) is due to extraordinarily low implied risk premiums for default risk and inflation risk (to name just two components of the real yield). Why are implied long-term bond yields low? Clearly these low implied risk premiums for long-term bonds have been mainly driven by the Fed's artificial manipulation of the Treasury market.
While some pundits are confused, it seems pretty clear that equity markets have implicitly made this distinction between a high equity risk premium and a low bond risk premium. Otherwise, for example, the premiums on puts would be near record highs rather than being near record lows. Furthermore, if equity risk premiums were as high as some analysts seem to think they are, we would expect corporate bond spreads to be extremely high.
Precisely because put premiums are low and corporate bond spreads are at relatively normal levels, it is clear that we cannot explain current stock prices as a result of the combination of a low risk free rate and a high equity risk premium. Since the implied equity risk premium appears to be near normal levels it is clear that current stock prices do not reflect an expectation of ultra-low bond long term bond yields (TLT). It is relatively clear that stock prices, in effect, reflect an expectation of relatively normal 10Y bond yields of around 4.5% to 5.5% in the future.
Tapering is mostly irrelevant to the valuation of stocks at the present time because equity values and long-term bond yields have almost completely decoupled. This decoupling, which started many years ago, is in part due to extraordinary and temporary economic conditions, but mainly to Fed manipulation of long-term interest rates via QE.
Most pundits think that the end of QE will be bad for the general stock market and index ETFs such as SPDR S&P 500 (SPY) and SPDR Dow Jones Industrials Average (DIA). I do not agree. Anticipation of the end of QE, in the context of a tapering cycle, may trigger a garden-variety stock market correction at some point. But for reasons I will elaborate on in future articles, I believe that precisely at the point when the end of QE becomes clearly visible, the US stock market may go parabolic and enter into a bubble phase.
In the meantime, don't sweat "taper" or "no taper" too much. A value of 1722 on the S&P 500, combined with operating EPS estimates of around $110, means that the stock market has already largely priced in tapering, the end of QE and a normalization of long-term bond yields. The exception may be certain categories of dividend stocks such as REITs (VNQ) and Utilities (XLU), which are widely utilized by investors as long-duration fixed income substitutes. Tapering and the end of QE, combined with relatively unattractive valuations, imply likely continued underperformance for these income-producing sectors.