Last August I wrote an article that highlighted the wide spread between the earnings yield on the S&P500 and the yield on treasury bonds. At the time the S&P 500 was in the 1,050-1,100 range which produced an earnings yield of around 7% based on consensus earnings expectations.
Meanwhile 10 year treasury yields had plunged below 3% in anticipation of QE2, producing a net spread between the two of more than 4%. Stocks were a better investment than bonds back then, and soon afterwards the equity market began a rally that took it some 25% higher before today’s list of concerns induced a pull-back. Treasury yields also rose over than time though in recent weeks they’ve dipped back below 3%.
Which brings us to today’s comparison. This morning The Wall Street Journal noted that 2011 full year earnings estimates provided by equity strategists are around $95. Consensus earnings using bottom-up forecasts are higher, which was the point of the article but that’s another story. $95 in earnings on today’s S&P500 of 1,280 is 7.4%, compared with 10 year treasuries of 2.9%. The spread between the two is back to where it was last Summer, in fact it’s even wider. Bonds are once again an unattractive investment.
This is not to ignore the risks currently facing investors. U.S. GDP growth has been disappointingly weak, and the headwinds from high gas prices as well as continued soft housing are weighing on the near term outlook. In addition the European debt crisis meanders on, with the entire world acknowledging Greece’s inability to satisfy its obligations while the EU and IMF persist in throwing good money after bad.
This week’s vote on austerity in the Greek parliament will usher in another round of tax revenue and privatization targets that are unlikely to be met. For this reason the Euro looks vulnerable, and if there are any surprises they’re likely to be negative ones.
Our equity accounts remain fully invested. We think there are good values to be found in selected stocks. One of our biggest positions in Microsoft (MSFT). It’s been a value trap for many investors, but they’ll likely earn $2.58 a share this year and $2.77 next (their fiscal year end is June), and with cash net of long term debt of $38 BN or $4.50 per share the stock is at a P/E of 7.5.
We have also been adding to positions in retailers – specifically we like Family Dollar (FDO). Their low-income customer base will benefit from cheaper gas, and slower growth tends to help this sector as cash-strapped consumers trade down. But FDO also has the opportunity to improve its margins; their sales revenue per square foot is only $163 whereas Dollar General (DG) manages $194. FDO’s operating margin is only 7.3% compared with 10.7% at Dollar Tree (DLTR). Improving these metrics should allow FDO to grow earnings faster than its peers. Holders of their stock include a number of value-seeking investors such as Pershing Square, Lone Pine and Paulson. Nelson Peltz offered $55-60 for the company earlier this year, and management’s rejection suggests they should have some concrete plans to raise the stock price themselves.
In Fixed Income we continue to focus our interest rate risk around the two year sector of investment grade bonds. We don’t like the risk of longer maturities – yields are way too low given the U.S. fiscal position. We continue to have some exposure to emerging market currencies where inflation, interest rates and growth are higher. However, we have trimmed this back recently as we think the EU/IMF/ECB management of Greece’s unsustainable debt load is looking more likely to induce a crisis before the inevitable restructuring. This would be negative for the Euro, and therefore positive for the US$ against most currencies including emerging markets.
Disclosure: Author is Long MSFT, FDO
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