RUTHFULLY YOURS

PIMCO managing director Bill Gross got the financial world’s undivided attention with his “stocks are dead” pronouncement July 31. There is some truth to the statement: expected returns are declining across all markets. But the market does not look at returns, but rather risk-adjusted returns. What has changed is not just the returns, as Gross correctly observed, but also the risk adjustment.

On July 23, my firm Macrostrategy LLC published a study of the new equity valuation that sheds light on the problem that Bill Gross emphasized. Given the controversy it seems worth sharing this paper with a broader public.

Visible and reliable cash flows trade at an unprecedented premium as bond yields collapse. Valuations of utility, tobacco, energy trust and other big dividend payers are stupidly rich and

are likely to remain so. A sea-change in equity valuations has put a premium on secure cash flows while amplifying the effect of uncertainty. It is possible to measure these changes by a number of statistical means, some direct, some indirect.

Apart from the number crunching, it’s worth recalling the Soviet-era joke about the listener call-in program on Armenian radio. A listener observes that in Marxist theory, the present era of socialism will give way to the glorious future of communism. The question is: Will there be money under communism? After considerable delay, Armenian Radio replies: Rightwing revisionists claim that there will be money under communism and leftwing extremists say that there will be no money. The dialectical solution is that some people will have money and others won’t.

The same applies to stocks: In the present era of crony capitalism and state encroachment, some equities will be dead and others won’t. We are living through an unprecedented shift to risk aversion.

As we see in Exhibit 1, the most reliable predictor of equity price returns in the past two years has been volatility – the least volatile sectors have the highest returns. The horizontal axis is the average implied volatility of SPDR ETF’s corresponding to major S&P sectors.

Exhibit 1: Implied Volatility vs Two-Year Price Returns, Major S&P Sectors

Source: Bloomberg

Volatility (at least the VIX index) is low, but risk aversion is high. How are we to explain this? Volatility as measured by standard deviation of returns assumes a normal distribution of returns, whereas investors know that the distribution is far from normal. That explains why equities have paid such a high price for volatility during the past two years.

Exhibit 2: Implied Volatility vs Returns (Data for Exhibit 1)

Source: Bloomberg

It is a bad time for the market when utilities trump other sectors, but they did so during the past two years (technology came close, but without Apple would have lagged far behind). Shown in Exhibit 2 are price returns only; when dividends are included, total returns to utilities rise by another 8%, bringing utilities’ two-year returns to 30%.

Another sign of times is the fact that utilities and consumer stables traded in lock step with Treasuries during the past three years – a noteworthy break from past trading patterns. Exhibits 3 and 4 below show a close relationship between bonds and the stocks with the most stable cash flows, namely utility and consumer staples. The scatter graph of bond yields against stock prices in these two sectors shows a more-or-less straight line relationship.

Exhibit 3: Utility Stocks Trade with Treasuries During the Past Three years …

Source: Bloomberg

Exhibit 4: … So did Consumer Staples

Source: Bloomberg

Exhibits 3 and 4 show daily data for the past three years. If we take a much longer sample, though, the linear relationship between utility stocks and bond yields turns out to be an anomaly of very recent vintage. The little spike jutting out to the left on the chart in Exhibit 5 is the recent correlation of utilities and bonds. It didn’t used to be that way. On the contrary, for the most part utility stocks traded inversely to bond yields.

Exhibit 5: 10-Year Treasury Used to Trade Inversely to Utilities: 1989 through Present

Source: Bloomberg

This is all the more remarkable given that the broad market is getting more inversely correlated with bond prices, as per Exhibit 6.

Exhibit 6: Correlation of Bond Yield and S&P 500

Source: Macrostrategy, Bloomberg

Exhibit 6 tells us, in effect, that the stock market didn’t care much about bond yields during the 1990s. In the days of unlimited hopes for the cyber-future, bond yields could do whatever they wanted, and the stock market didn’t care. During the 2000s, though, as Treasury bonds became a store of value and a safe harbor investment, the stock market cared a great deal about bond yields. Better said, both stocks and bonds cared about the same thing, namely, getting out of the path of risk.

Exhibit 7: The S&P becomes more correlated with the 10-Year Treasury as the 10-Year Treasury Yield Falls

Source: Macrostrategy, Bloomberg

I had to look at Exhibit 7 a few times before my eyes would focus. Econometrically, there is little doubt that the falling 10-year yield corresponds to a greater sensitivity of stocks to bond yields.

As bond yields fell, stock prices became more positively correlated with bond yields, that is, stocks tended to fall further when bond yields fell.

That is another way of saying that the market became more risk averse. After the fact that seems obvious, but it’s useful to get the license plate of the truck that ran us over.

The market isn’t shunning stocks: it is shunning uncertainty. We saw that there is a clear, linear relationship between volatility and sectoral returns during the past two years. More importantly, we detect an entirely different trading pattern in stocks with visible, reliable cash flows (utilities and consumer staples): these sectors of the market trade increasingly like bonds. The broad market, though, trades in the opposite direction of bonds (risk aversion causes bond yields and stock prices to fall together.

This bifurcation of the market, finally, is something new and unwelcome. It implies an aversion to uncertainty of a kind that we have not seen in two generations, and a willingness to pay increasing amounts for secure cash flows that we have not seen in a very long time.

Exhibit 8: Price Rise in Utility Stocks Is Entirely Due to a Higher Price for Earnings

Source: Macrostrategy, Bloomberg

With a 70% dividend payout ratio and stagnating capital investment, the long-term outlook for utilities earnings is poor, but investors continue to pay a higher price for them – comparing them directly to the alternatives in the bond market. In other words, expected returns for secure investments are falling, while the market is shunning risk investments in general.

It is no news that entrepreneurship has been depressed for the past several years. The attitude of the federal government is at least partly to blame, as the furor over President Obama’s “You didn’t build that” speech makes clear. Whether other factors are to blame – the aging of the prospective pool of entrepreneurs, the 40% reduction of average household wealth, or international competitiveness – is hard to measure.

What we can measure, though, is the remarkable extent to which risk aversion has changed equity valuations during the past several years. It is sobering to consider the implications for equity market performance as well as economic growth.

Spengler is channeled by David P Goldman. His book How Civilizations Die (and why Islam is Dying, Too) was published by Regnery Press in September 2011. A volume of his essays on culture, religion and economics, It’s Not the End of the World – It’s Just the End of You, also appeared last fall, from Van Praag Press.