10 Valuation Charts

by: Calafia Beach Pundit

Here is a random selection of charts that track valuations of various securities and asset classes. It's somewhat of a mixed bag, with Treasury yields still very low, corporate debt approaching highly-valued levels, gold still expensive, and the dollar near the low end of its historical valuation.

Five-year Treasury yields are up over 100 bps from their all-time lows of last year (0.6%). But with the exception of last year and early this year, at their current level of 1.7% they are lower than at any other time in history. Relative to inflation, five-year Treasury yields are very near the lowest they have ever been. Treasury yields, in other words, are still exceedingly low these days and thus are richly valued. For several years now I've been thinking that yields were more likely to rise than fall, but I have been wrong - with the exception of last year. I still think they are more likely to rise than fall, mainly because I think the Fed is going to be forced to raise interest rates sooner than expected.

The chart above compares five-year Treasury yields to core consumer price inflation. The scales are offset a bit to reflect the view that yields should normally trade at a level that is somewhat higher than current inflation, if only to compensate investors for the uncertainty surrounding the future level of inflation. Five-year Treasuries yielding 1.7% today offer a very small cushion to investors, since core inflation over the past year has been 1.8%. The explanation for the noticeable divergence in yields and inflation that began in 2011 could be that the bond market became overly concerned about the risk of another recession and/or the emergence of deflation. Both those risks have receded in the past year, however, which is why yields are up from incredibly low levels.

Nominal and real yields on Treasuries are roughly in line with historical norms. The spread between the two - expected inflation - is right in line with current and historical inflation. Neither one looks attractive relative to the other, unless you are worried that inflation will rise. But if inflation rises, then both real and nominal yields will rise as the Fed tightens monetary policy. And nominal yields would rise by more than real yields because inflation expectations would rise. So the downside risk to nominal Treasuries looks greater to me than the downside risk to TIPS. TIPS would also benefit, of course, from rising inflation, since that would boost their coupon payment. But in a rising inflation rate environment TIPS would almost certainly suffer from declining prices because real yields would tend to track the rise in nominal yields. TIPS are not a slam-dunk investment if you are worried about inflation.

Corporate credit spreads are getting pretty tight (i.e., the spread between corporate bond yields and Treasury yields of comparable maturity is pretty small). As the chart above shows, both high-yield and investment grade credit spreads are now at post-recession lows, and they are approaching their all-time lows. I note that they traded at current or lower levels for at least three years during the previous business cycle expansion, so it's not unreasonable to think that they might trade at or near current levels for the next few years. But, as is the case with five-year Treasuries, the cushion against uncertainty is pretty small. The upside potential of investments in corporate bonds is now relatively small, whereas their downside risk is relatively large. Asymmetrical risks like this argue for trimming one's exposure to the sector.

The chart above shows the spread between high yield and investment grade corporate bonds, otherwise known as the "junk spread" - the extra amount you are paid to accept the additional credit risk of high yield bonds. This spread too is very close to its all-time lows. High-yield debt can still be attractive to conservative investors because of its extra yield, but to realize that extra return you need the economy to continue to grow by 2-3% and you need inflation to remain relatively low. If the economy grows faster, then all yields are going to rise, and the extra yield on corporates will be consumed at least in part by declining bond prices.

Corporate bond yields are also very close to all-time lows. I don't worry so much about spreads getting wider as I do about yields going up, which would almost certainly accompany a general rise in Treasury yields. Owning corporate bonds these days exposes investors to two major sources of risk: default risk and rising interest rate risk. Of the two, I think rising interest rate risk is the bigger of the two, because I don't see a recession for the foreseeable future, but I do see the potential for the economy and/or inflation to pick up and for the Fed to raise short-term interest rates sooner than expected.

Credit Default Swap spreads tell the same story as corporate credit spreads. Default risk is quite low, but it could go lower. Investment grade Five-year CDS yield about 60 bps more than Five-year Treasuries, while high-yield CDS yield about 300 bps more. These securities would likely provide decent returns if the economy continues to grow at a relatively slow pace of 2-3% and inflation remains subdued. Faster growth and higher inflation, however, would likely prove a bit painful.

The first of the above two charts shows the nominal, trade-weighted value of the dollar against a basket of major currencies. The second shows the inflation-adjusted, trade-weighted value of the dollar against a basket of major currencies and against a basket of most currencies. By any measure, the dollar is only about 5-10% above its all-time lows. Barring some disastrous mistakes on the part of the Fed, the dollar's downside risk looks relatively small to me. I think it's more likely that the dollar strengthens over the next several years, especially if the political mood in Washington becomes more favorable to investment. In this regard, I note the rising chances of a bipartisan deal between Rand Paul and Harry Reid which would create a tax holiday for the repatriation of corporate profits. The asymmetrical risk of the dollar argues for approaching non-dollar investments with caution, unless one is extremely bearish about the future of the U.S. economy.

Gold is substantially off its highs, but I think it's still very expensive. I note that the inflation-adjusted value of gold over the past century has averaged about $500-600 per oz. As the chart above shows, gold is still significantly more expensive than commodity prices. An investment in gold is likely to pay off only if the Fed makes a huge mistake and inflation soars. As it is, I think gold today is priced to a substantial increase in inflation, and has been for years. The fact that inflation has failed to rise as the gold bugs hoped is a major reason that gold has declined from its peak of $1900/oz.