U.S. Equity Bears Still Can't See The Bottom But Now The Only Way Is Up

Includes: CVX, SPY
by: Daily Trading

As it has done for at least the last two years, bearish sentiment continues to rule supreme among the bulk of investors, shell-shocked by the continuing ructions in world markets.

I have lost track of the number of articles I have read which articulate, in no uncertain terms, that the world economy is heading for recession and that low growth is the best investors can look forward to over the coming months, if not years.

However, while many people are happy to embrace the doomsayers' negative outlook as to where the global economy is going, few understand that this overly gloomy consensus is already well and truly priced into today's financial markets. Indeed, at the height of the sell-off on Friday 1st of June, when the S&P 500 traded at 1277, it appeared as if the US stock market was about to fall into the abyss again.

But, while everyone was well aware of the level of the S&P, or at least the S&P's chart "pattern", few investors would have realized that the earnings yield differential between the S&P 500 and the US 10-year Treasury note yield was 6.30%. And, more importantly, only a small minority would have appreciated its significance.

An earnings yield differential of 6.30% means that the earnings yield of the S&P 500 (EPS of the S&P/S&P 500 index level) was 630 basis points above the yield of the US 10-year Treasury note.

In itself this may not mean too much, but if I said that only once before in the last 50 years has the differential been higher, the magnitude of the differential might attract more attention. Case in point - at the very worst of the GFC, in March 2009, the differential got to 6.85%.

Earnings Yield Differential of S&P 500 and US 10yr

Click to enlarge

And now the picture gets clearer, because if the earnings yield differential between the S&P 500 and the US 10-year Treasury remains close to the GFC levels between October 2008 and April 2009, then it appears that stock and bond markets have priced in the occurrence of another financial crisis equal in magnitude of the GFC.

Crucially, by remaining bearish on equities and bullish on bonds, the only way investors will make money, or at least, not lose it, will be if a crisis greater in magnitude than the GFC occurs.

Put in context, the extreme extent of this prevailing sentiment of bearish gloom should not be taken lightly because, after all, the GFC was the greatest financial crisis to occur this side of The Great Depression. In my mind, I don't think betting on another Great Depression is trading with the odds in your favour and it certainly isn't likely to be very rewarding to the average mom and dad investor!

Let's consider why.

The only way for equities to be expensive now is for there to be a complete collapse in earnings. This won't happen if companies in the S&P 500 merely maintain their current level of earnings (i.e. for there to be no earnings growth) over the coming quarters. It is interesting to note that analysts continue to increase their earnings estimates for stocks within the S&P 500 in spite of all the negativity that has prevailed over the last few months.

To illustrate just how cheap U.S. stocks are, or at least how overly pessimistic investors are, consider Chevron (NYSE:CVX) which is a company that most investors can relate to in terms of its products. Chevron is also the 7th biggest company by market cap in the US and 10th largest in the world. Currently Chevron trades on a P/E of some 7.4 times with annual earnings of some $27bn and a valuation of $198bn.

What does this mean in practical terms? Well, if you were to buy Chevron outright, in so doing taking the company private, and the company didn't grow its earnings for the next 7.5 years (i.e. it continued to earn $27bn p.a.), then your $198bn investment would be fully paid for in 7.5 years.

What about dividends? Chevron has a dividend yield of 3.57%. This sounds interesting considering that the yield of the US 10-year Treasury is some 1.6%.

However, things get a whole lot more interesting when you consider that Chevron is only paying out about 23% of its earnings as a dividend. So, if Chevron was to pay out half of its earnings as a dividend (typical of most mega-cap companies), then its dividend yield would be about 6.7% - that is insane!

So, with this in mind, before being so quick to jump to conclusions and hitting that big sell button, investors should re-examine the fundamentals underlying the market to understand when it's the right time to be bearish and, by implication, then when they should join the bulls.

Think carefully of what is already priced into U.S. equity and treasury markets.

U.S. equities relative to treasuries are already priced for a repeat of the greatest crisis since the Great Depression.

But, even if corporate America's earnings do not grow at all over the coming years, they still offer significant value, perhaps the best value in a couple of generations.

Disclosure: I am long DIA.