Category: Chart of the Week

Do Current Valuation Levels Suggest an Upcoming Correction?

Over the past few years, investors have become concerned about higher equity valuations and the potential for another pullback or crash. The U.S. equity market is currently in its third longest bull market dating back to WWII, increasing worries that the run may be coming to an end soon.

Over the past few years, investors have become concerned about higher equity valuations and the potential for another pullback or crash. The U.S. equity market is currently in its third-longest bull market dating back to WWII, increasing worries that the run may be coming to an end soon.

This week’s chart examines modern valuations for the S&P 500 to give us a snapshot of where the equity markets are relative to the last 35 years of market data. Using the trailing 12-month P/E ratio, we see that historical valuations are somewhat normally distributed, with the mean falling between 16x and 18x earnings. As of June 18th, the P/E ratio was at 18.75, with its range highlighted in red on the chart. Though this is above average historical valuations, it is still far below the high end of the spectrum that we saw during the tech bubble.

This does not necessarily mean there will not be a crash sometime soon since many factors other than valuations can affect the market. In the second half of 2007 leading up to the recession, valuations were within the mean bar of 16x–18x, yet the index collapsed due to earnings falling dramatically after the housing crash. Though the potential for a pullback is ever-present, a significant correction based solely on valuations seems unlikely.

Relative Yields for REITs and MLPs Trending Up?

Given the prolonged low rate environment in the aftermath of the credit crisis, investors have been on a continual search for yield. Historically, REITs and Master Limited Partnerships (“MLPs”) have been among the highest yielding asset classes, which led to strong performance in the years following the 2008 financial crisis.

Given the prolonged low rate environment in the aftermath of the credit crisis, investors have been on a continual search for yield. Historically, REITs and Master Limited Partnerships (“MLPs”) have been among the highest yielding asset classes, which led to strong performance in the years following the 2008 financial crisis. However, since the taper tantrum in May of 2013 MLPs and REITs have underperformed the S&P 500 by 1,136 and 648 bps, respectively.1 Currently, REITs2  and MLPs3  are yielding 3.8% and 6.0% compared to the S&P 500 yield of 1.9% as of May 2015.

This week’s chart looks at the historical relative yields of REITS (red lines) and MLPs (blue lines) compared to the S&P 500. The chart shows that if you owned MLPs or REITs since June 2006, on average, you were receiving 3x and 2x yield over the S&P 500 respectively. However, by early 2013 both MLPs and REITs looked expensive based on their yields relative to the S&P.4 Of course, given the underperformance of both MLPs and REITs over the last few years, the relative yields of both asset classes are again starting to look more attractive. REITs still seem a little expensive as yields remain relatively low (compared to history) but MLP yields (relative to the S&P) are now above their long-term average and look relatively attractive, and may present an opportunity for investors to boost portfolio returns.

1 As of May 29, 2015
2 REITs are represented by the FTSE NAREIT All Equity REITs Index
3 MLPs are represented by the Alerian MLP Index
4 Prices are inversely related to yields: if the yield is below the average it is more expensive

Compelling Valuations for Energy Distressed Debt

Given the environment of record issuance and low yields, one is hard-pressed to find fixed income bargains. With the S&P 500 and P/E ratios at record peaks, bargains in equities are similarly few and far between. Energy distressed debt, however, is presenting extraordinary bargains.

Given the environment of record issuance and low yields, one is hard-pressed to find fixed income bargains. With the S&P 500 and P/E ratios at record peaks, bargains in equities are similarly few and far between. Energy distressed debt, however, is presenting extraordinary bargains. Since the energy dislocation began, an unprecedented amount of high yield energy bonds, especially those of shale fracturing E&P companies, have been trading in distressed/stressed territory. As shown in this week’s chart, the bars represent the par value of U.S. high yield energy bonds. The blue bars show the cross-section for May 2015, when $2.5 billion of bonds were priced at zero to 20 cents on the dollar, $2.1 billion were at 20 to 40 cents on the dollar, $7.0 billion were at 40 to 60 cents on the dollar and $19.9 billion were at 60 to 80 cents on the dollar. These values sum to $32 billion, or 15%, of bonds trading between zero and 80 cents on the dollar, which is known as distressed/stressed territory. Contrast this with June 2014, shown in the red bars, when only $0.8 billion, or less than 1%, were distressed/stressed. Clearly, this is an opportunity set that has emerged in the last twelve months and could pay off for investors.

There are two key channels through which investors can access this unprecedented opportunity. One is investing with an energy direct lender, which has two advantages. First, direct lenders can buy into a company’s debt at the top of the capital structure, above any existing bank loans and high yield bonds. This, in turn, gives the investor first-in-line access to the company’s assets in the event of a liquidation. Second, a direct lender can create further protection by negotiating heavy covenants, in contrast to the covenant-light bank loans and high yield bonds existing in the marketplace today.

The second approach is investing with a manager that specializes in buying distressed debt and working with the issuer through a restructuring to extract outsized value from the position. Because such managers would invest in existing covenant-light paper, it is beneficial to choose one that diversifies across oil and gas, coal, electric utilities, and alternative energy.

While distressed energy debt may not be appropriate for all institutional investors, it could also prove accretive to clients in the coming years. As we have seen many times in the past, buying at depressed prices often leads to outsized returns in subsequent years. Given the overall high valuations in the financial markets, we believe distressed energy offers a compelling valuation at this time and could help boost future portfolio returns.

Divergence of Unemployment Rates in Europe

The Maastricht Treaty mandates the European Central Bank (“ECB”) to target inflation. In contrast, the Federal Reserve targets maximum employment, appropriate inflation, and moderate long-term interest rates. When comparing unemployment rates between the world’s two largest currency blocks, the United States has seen a much stronger recovery with lower levels of dispersion between states.

The Maastricht Treaty mandates the European Central Bank to target inflation. In contrast, the Federal Reserve targets maximum employment, appropriate inflation, and moderate long-term interest rates. When comparing unemployment rates between the world’s two largest currency blocks, the United States has seen a much stronger recovery with lower levels of dispersion between states. The U.S. benefits from its ability to utilize fiscal stimulus, automatic stabilizers, and unconventional monetary policy.

On the other hand, the European Central Bank does not have the power or the authority to use automatic stabilizers on behalf of individual nations dealing with asymmetric shocks. It can only expand and contract its balance sheet by purchasing debt or issuing bonds as a third party. As this week’s chart shows, one of the direct consequences is that improving unemployment – among other economic challenges – is extremely difficult across a diverse set of countries. Thus, unlike the United States which has seen improvement in unemployment across all of its states, a notable divergence continues to exist across European nations and remains a challenge for future economic growth in select countries.

Is Home Ownership a Thing of the Past?

Home ownership has historically been part of the American dream; however, recent data trends show that more consumers are postponing or bypassing this life event in favor of renting. The sting of the Great Recession still resides within consumers’ minds, many of whom are still struggling from a period in which millions of homes went into foreclosure and trillions of dollars of home equity was wiped out.

Homeownership has historically been part of the American dream; however, recent data trends show that more consumers are postponing or bypassing this life event in favor of renting. The sting of the Great Recession still resides within consumers’ minds, many of whom are still struggling from a period in which millions of homes went into foreclosure and trillions of dollars of home equity was wiped out. While the devastating housing crash is certainly one culprit, a shift in millennials’ attitudes could also be contributing to this change in sentiment.

In this week’s chart, we examine the declining rate of homeownership versus the increasing costs of renting. Despite the attractive level of home affordability, homeownership is at its lowest level in 29 years and monthly rents are at an all-time high. In ten short years, the percentage of non-vacant housing units occupied by the unit’s owner has declined from its 2005 peak of 69.1% to just 63.7% this year. Meanwhile, the median monthly asking rent has risen 31.4% during the same period. The U.S. Census Bureau reported that the most recent median asking sales price was $149,500, the same nominal levels we were seeing in the latter part of 2005 but significantly lower than the 2Q 2007 peak of $201,500.

While the U.S. economy has made great strides in its economic recovery, the housing market has yet to come out of its shell. The impact of increased home purchase activity and its resulting consumption effect would be a boon to the domestic economy. Thirty-year mortgage notes can still be obtained for less than four percent interest, but the availability of cheap credit has not been enough to drive more millennials into homeownership. As we debate the impacts of tightened monetary policy by the Federal Reserve, the consequences of rising interest rates and its direct effect on the housing market cannot be ignored.

Still Waiting for Wage Growth

On Friday, April’s unemployment rate was announced at 5.4%, the lowest reading since May 2008 and significantly down from its peak reading of 10% in the aftermath of the Great Recession. Despite the low participation rate (62.8%), the dramatic improvement in the unemployment rate should be viewed as a positive development for the United States economy.

On Friday, April’s unemployment rate was announced at 5.4%, the lowest reading since May 2008 and significantly down from its peak reading of 10% in the aftermath of the Great Recession. Despite the low participation rate (62.8%), the dramatic improvement in the unemployment rate should be viewed as a positive development for the United States economy.

Although the unemployment rate has recovered, wage growth continues to stagnate, as shown by our chart this week. In looking at the chart, a negative correlation between unemployment and wage growth is abundantly clear and makes sense intuitively: when unemployment is high, workers do not have pricing power to demand higher wages, but when unemployment is low and demand is high for employees, firms are forced to offer higher wages to entice workers. The most recent recovery in the unemployment rate, however, has not been accompanied by the ascension in wage growth that is to be expected. So while the lower unemployment rate is encouraging, it is difficult to label the labor market as fully recovered until we see more tangible growth in hourly earnings.

Will Student Debt Suffocate Economic Growth?

According to the National Center for Education Statistics, an estimated 1.8M students across the country will graduate this month with their undergraduate degrees. These graduates are entering an ever improving job market as shown by the latest unemployment figure of 5.5%, but they are also graduating with an increasing amount of debt as shown by this week’s chart.

According to the National Center for Education Statistics, an estimated 1.8M students across the country will graduate this month with their undergraduate degrees. These graduates are entering an ever-improving job market as shown by the latest unemployment figure of 5.5%, but they are also graduating with an increasing amount of debt as shown by this week’s chart.

Total student loan debt levels have grown by over 64% since the end of the recession in 2009. Wage growth, on the other hand, has been modest, increasing just over 10%. There are two major concerns about this disconnect between student debt and wage growth. The first is that there will be a widespread pattern of defaults on this outstanding debt, as students are unable to keep up with the loans after graduating. The second is a reduction in consumption from millennials who are spending a larger percentage of their incomes on debt service, rather than consuming goods and services. Together these two issues could be a significant drag on economic growth.

Is Real Estate Overvalued?

The core real estate market has enjoyed a solid run over the last five years. However, outsized returns do not last forever and for this reason investors are starting to question future return prospects for the asset class. There are several metrics to consider when answering such a question and this week’s Chart of the Week looks at one such metric: new supply.

The core real estate market has enjoyed a solid run over the last five years. However, outsized returns do not last forever and for this reason, investors are starting to question future return prospects for the asset class. There are several metrics to consider when answering such a question and this week’s Chart of the Week looks at one such metric: new supply.

The chart above compares new supply as a percentage of existing stock across the four main property sectors. As the chart indicates, current levels of new supply remain below the pre-recession averages for three out of the four sectors. That affords some comfort. However, new supply of apartment properties has exceeded its pre-recession average. Indeed, a lot of the supply in apartments has been driven by an increase in true rental demand, but the data suggests that the apartment sector may come under pressure in the near- to medium-term if new supply continues to rise. According to this metric, opportunity still remains in the retail, office, and industrial sectors. Ultimately, though, new supply is just one metric to consider when gauging the current state of the real estate market. Other important items to monitor include performance, valuation, debt, income, and capital flows. Our recently released newsletter, The State of Real Estate: Is the Run Over?, analyzes these metrics to formulate a view on future return prospects for the asset class.

Has the Drop in Oil Prices Been a Drag on the U.S. Economy?

Over the past few quarters there has been much discussion about how the recent plunge in oil prices would impact the U.S. economy. While there were expectations of both positive and negative effects associated with lower oil prices, the general consensus amongst economists was that this would have a net positive impact on the U.S. economy.

Over the past few quarters, there has been much discussion about how the recent plunge in oil prices would impact the U.S. economy. While there were expectations of both positive and negative effects associated with lower oil prices, the general consensus amongst economists was that this would have a net positive impact on the U.S. economy. Cuts in capital expenditures from U.S. oil producers (which have been a significant contributor to GDP growth for the past several years) were expected to be a drag on economic growth. At the same time, lower energy costs for consumers were expected to result in increased disposable income and thus increased consumer spending, which would boost economic growth. Given that the U.S. is a net importer of oil, the benefit to consumers was expected to more than offset the decrease in capital spending from producers, resulting in a net positive impact.

Since low oil prices have persisted for several months now, we are starting to get an indication of the impact on the economy, and at this point it does not appear to be nearly as positive as expected. It appears as if the economic drag from decreased capital expenditures from oil producers has been greater than the benefit from lower oil prices. While the drop in capital expenditures from oil producers has more or less been in line with expectations, the increase in disposable income has not translated to the increase in consumer spending that was anticipated. Consumers appear to be saving, rather than spending, this increased disposable income. As the chart illustrates, from June 2014, when oil peaked at approximately $115 per barrel, to February 2015 (the most recent date data is available for), annualized household spending on energy has decreased from approximately $645 billion to approximately $533 billion, representing a decrease of approximately $112 billion. Over the same time frame, annualized household saving has increased from approximately $658 billion to $768 billion, an increase of approximately $110 billion.

Thus far, the negative consequences from lower oil prices (reduced capital spending and job cuts from the energy sector) have been a drag on the U.S. economy, while the benefits from lower oil prices (increased consumer spending) have not yet had the positive impact that was expected. This phenomenon may help to explain some of the disappointing economic data observed during the first quarter. Consumers are often slow to adjust spending habits, and that may well be the case here, meaning that consumer spending will likely be one of the most influential economic data points in the coming months.

Which Equity Sectors are Most Sensitive to Rising Interest Rates?

Over the past few years there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

Over the past few years, there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

This Chart of the Week examines what has happened historically to the sectors of the S&P 500 index when rates on the 10 yr Treasury rise substantially. The chart compares the average monthly returns during seven rising rate periods to the average monthly returns during this entire timeframe. As a whole, the S&P 500 has generally outperformed during these time periods, along with most sectors. Industries that tend to be more cyclical, such as information technology, consumer discretionary, and materials featured the largest outperformance. On the other hand, more conservative sectors failed to beat their averages, with utilities and telecom delivering negative monthly returns. Though it is important to remember that historical results may not always persist in the future, the largely positive returns shown in the chart should help ease the fears of an equity market correction when rates begin to rise.