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Hard-to-please bond investors hold sway over stocks

Michael Santoli
Michael Santoli

We can discuss Greece, China, moving averages and crowded trades without end. And we will.

But over any significant span of time, the stock market is driven by corporate profits and what investors are willing to pay for them.

Using this undeniable two-factor principle, it makes almost perfect sense for the market to be trading exactly where it is.

Near the end of July 2014 – nearly 15 months ago – the collective forecast for the next 12 months’ S&P 500 (^GSPC) companies’ per-share earnings was $127.71. Right now, the 12-month forward forecast is at $127.62, within a whisper of where it was a year-and-a-quarter ago.

And the S&P 500 itself was at 1987 late July of last year, or 15.6-times forward earnings. Today, the index is at 1995 as of last night’s close, 15.6-times expected earnings.

Of course, between then and now, the index traded down 8% by last October and then rallied 17% from there into the May high, before the latest deep pullback and partial recovery of the past couple of months.

This doesn’t mean companies or the cycle is in the same condition they were in 15 months ago. Or that the profit estimates right now are sure to be accurate one year out. But given what investors have to work with in terms of fundamentals, the corporate story is similar enough in the aggregate.

How generously the market is willing to value those earnings prospects is the trickier part of the story. Everything from global growth rates (ebbing), profit margin trends (weakening) and the broad public mood (rather anxious and confused) feed into the market price-earnings multiple.

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But one crucial touchstone is corporate bond yields, which indicate the cost of debt capital that in theory should have some relation to how much equity “costs” in terms of earnings.

Back in July 2014, the credit markets were quite strong, with bond investors willing to accept little extra yield over government rates. For triple-B rated corporate debt – the lower end of high-grade credit – the prevailing yield in July 2014 was 3.43%. Today, that yield is 4.07.

That’s not a huge rise in the broad sweep of time, but it shows at the margin the capital markets are less forgiving.

For riskier credits found in the junk-bond indexes, things look more challenging, to say the least. The effective yield on the junk index in July 2014 was 5.52%. It’s now just under 8%. This speaks to a maturing credit cycle, mass carnage in energy-related debt and a general curtailment of risk appetites.

The yield spreads in junk have been rising pretty steadily, though they’ve eased back slightly in recent days.

If this earnings season plays to script and about two-thirds of companies beat reduced forecasts, and there isn’t too much more erosion in future earning prospects or cash flow margins, then stocks can probably tough it out fine.

But all else being equal, this would suggest that even if stocks can continue reclaiming more lost ground, they would be hard-pressed to stretch back toward their heights without some important improvement in credit markets.

Stock investors looking for the market to rally hard in the fourth quarter and put in another run toward all-time highs might be channeling Bill Clinton in his first term, who famously expressed profane alarm that his fiscal ambitions were being thwarted by “a bunch of [finicky] bond traders.”

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