Why the US labor recovery supports equities and high yield credit (Part 10 of 13)
Equity markets lead employment data
The below graph reflects the dramatic recovery in U.S. equity prices since the 2008 crisis and the exodus of the Baby Boomer generation from the labor force. The outperformance of the broadest of the three major broad equity market industries below, the Russell 2000 (with 2,000 constituent equity components) has outperformed the S&P 500 (with 500 constituent equity components) and the Dow Jones Industrials (with only 30 constituent equity components). The following four articles examine investment options available to investors in the areas of both major equity index ETFs, as well as traditional and non-traditional fixed income ETFs. Investment choices in the area of equities include market breadth exposure and value versus growth exposure. In the area of fixed income ETFs, we’ll look at the trade-offs between high credit quality and low credit quality, as well as short duration exposure versus long duration exposure.
To gain a broader understanding of the other macroeconomic factors supporting the economic and investment-related views in this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Why the Russell 2000 outperforms narrower indices
“Market breadth” refers to the diversity of equity holdings. In the above graph, the Russell 2000 clearly has the greatest breadth, followed by the S&P 500, then the mere 30 component index of the Dow.
More price volatility in small companies
The broadest market index, the Russell 2000, outperforms other indices. This is because the Russell 2000 holds many smaller companies in its index relative to the S&P 500—and certainly relative to the Dow, which holds entirely the biggest companies from various industry sectors in its index. These smaller companies tend to have more risk, and they exhibit greater price volatility as a result.
As we see above, the inclusion of exposure to smaller companies in your investment exposure can enhance the return of the portfolio. On the other hand, during bad economic times, smaller companies can underperform larger global blue chip companies. The stock price of smaller companies tends to exhibit greater sensitivity to business cycles, as their profit margins may shrink or rise more dramatically than the margins of larger companies.
Higher cost of capital: Fewer advantageous financing opportunities for smaller companies
Similarly, smaller companies may face more expensive financing alternatives in the form of debt (bonds, bank loans) and equity issuance. In other words, these companies have a higher “cost of capital” relative to larger companies, as smaller companies typically involve a higher level of investment risk. This means smaller companies tend to outperform larger companies during a period of anticipated economic growth, though they underperform larger companies in a period of economic decline.
To see how value versus growth ETFs compare with broader indices ETFs, please read the next article in this series.
To learn more about these and other fixed income ETF investments, please see Fixed income ETF must-know: Has the bear market in bonds begun?
A credit comment: Yield versus quality—Sprint versus Verizon
Sprint (S) has a market capitalization of $36.17 billion (the value of all its equities), and it’s considered a high yield credit. Its debt is considered below the investment-grade cut-off of “BBB” rating, as it’s in the BB (junk bond or below–investment-grade) category. Reducing the firm’s $33 billion of debt by the $7.47 billion of cash holdings leaves approximately $25.5 billion of net debt, and a 1.29 debt-to-equity ratio. However, given the last quarter profit margin of -8.50%, the firm has seen a negative 18.48% return on equity. Sprint is a large company with $35.49 billion in sales revenue, and it still has $5.47 billion in earnings before interest and taxes (EBITDA) to service its net debt of $25.5 billion.
This is sufficient debt service capability, though a weakening economic environment in the USA could compromise the debt service ability in the future. With $48.57 billion in EBITDA and $42 billion in net debt, Verizon is clearly in a much stronger financial position than Sprint. Unless we see labor and productivity increases in the future, companies with weaker earnings margins like Sprint could face further pressures on their bond prices and higher yields. However, the 2013 Softbank merger or acquisition and capital infusion of $5 billion may also improve Sprint’s credit outlook and operating health going forward.
In contrast, Verizon has a market capitalization of $198.36 billion, and a credit rating of BBB+. Reducing the firm’s $96.61 billion of debt by the firm’s very large $54.13 billion cash position, we’re left with approximately $42 billion of net debt, and a 0.98 debt-to-equity ratio. In contrast to Sprint, Verizon has a positive net profit margin of 9.54%, and a 26.03% return on equity. Verizon’s revenues are $120.55 billion (roughly three times larger than Sprint’s) and Verizon also has a whopping $48.57 in EBITDA (six times larger than Sprint’s) to service its net debt of $42 billion—only 1.68 times larger than Sprint’s. Clearly, Verizon’s very large EBITDA earnings relative to its modest debt levels would suggest that even in the case of economic weakness—related to labor and consumption or most anything else—Verizon has a far superior ability to service its debt. Perhaps a strengthening labor market and overall economy can support Verizon’s operating margins and debt service capabilities relative to Sprint in the future.
Sprint currently has a August 15, 2007, senior unsecured bond yielding 2.95%, versus Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile US’ February 9, 2019, senior unsecured bond yielding 3.00%, CIT Group’s February 19, 2019, senior unsecured bond yielding 3.46%, and Caesar’s Entertainment’s June 1, 2017, senior secured bond yielding around 11.00%. (Bloomberg & Capital IQ, December 31, 2013 Quarter)
Equity outlook: Cautious
Should the debt ceiling debate re-emerge after the mid-term elections in November, and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Plus, even the global blue chip shares in the S&P 500 (SPY) or Dow Jones (DIA) could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY) or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the budget and federal debt issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment, or individual companies such as Wal-Mart Stores (WMT).
Without sustained improvement in economic growth data, there’s little doubt that the debt level issue and tax reform will be a big issue later in the year. Current economic data noted in this series suggests that the probability of the 2013 sequester issue returning—in one form or another—could be higher than many think. The data is simply not that robust—yet.
Equity outlook: Constructive
However, if investors are confident in the ability of the USA to sustain the current economic recovery as a result of the improving macroeconomic data noted in this series, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the S&P 500 (SPY) price-to-earnings ratio standing at 19.65 versus the historical average of around 15.50, the S&P is slightly rich in price—though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it’s possible to imagine that a large reallocation of capital that is “on strike,” including corporate profits, into long-term fixed investments. This could lead to greater economic growth rates and support both higher equity and housing prices as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF) or through individual growth-oriented companies such as Google (GOOG).
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