From the July newsletter of Provident Investment Management
The whole idea of “bond yield” seems like a relic of a bygone era. The death of yield is pushing all investors, big and small alike, out of their comfort zones. The stock market has been a beneficiary of low interest rates over the last seven years, but over the last one year the only sector enjoying positive double-digit returns has been utilities, which really trade more like bonds than stocks. For equity investors, the supremacy of utilities stocks may bring to mind those famous lyrics from the song “Born Under a Bad Sign”: “If it wasn’t for bad luck, I wouldn’t have no luck at all.”
Utilities might simply be “leading” the broader market higher. Market commentators have lots of different opinions about which sectors best predict where the overall market will go in the future — with highly volatile and economically sensitive semiconductor and transportation stocks usually getting the most votes. According to the scholarly studies, however, no sector reliably leads the rest of the market with a high degree of statistical evidence. The only sector with any statistical evidence as a predictor for where the rest of the market will go next has not been the “semis and transports,” but rather boring old utilities.
This relationship might be due to utilities’ high correlation with interest rates. Low prevailing interest rates support high stock values. Higher interest rates are bad for stock values. Whenever interest rates move stocks higher or lower, it’s the utilities stocks that get there first.
That argument would tend to support higher stock values. In an environment where interest rates are at levels that feel almost impossibly low, the S&P 500 is trading at 24 times the trailing-12-month average of its component companies’ composite earnings. This is near the high end of its historic range, but is by no means unprecedented. Something has to give. It seems unlikely that interest rates can stay at all-time lows without stock valuations drifting upwards out of their historical range.
Please don’t misinterpret that small bit of optimism as a market prediction an investor could take to the bank. One way that the historic relationship between stocks and bonds could come back into alignment without stocks going up or bonds going down would be for corporate earnings to decline, meaning that P/E ratios could rise without stocks actually going up.
Is this likely? It is already happening, although it may not continue for long. Corporate America is in a “profits recession,” with Q1 2016 marking the third straight quarter of lower year-over-year composite earnings for the S&P 500, and with another 4.9% decline predicted for Q2. These declines are almost entirely explained by low energy prices, which have obliterated the energy sector’s earnings without giving much help to other sectors.