Yesterday we discussed the divergence between the 10yr yield & SPX Index. I mentioned that the thing that ties them together is the cost of capital. Today I want to show that a little more directly

The chart today shows the Moody's Corporate Baa yld vs. the S&P 500 earnings yld. You can see they directionally move together though there has been a spread

In fact, the S&P 500 earnings yld has been below the Corp Baa yield since Sept of last year. This may not sound like much but that is the first time since the rallies in early 2009 it had happened

You see we have gone through different regimes of investor preferences. For all of the 90s, stocks were preferred for the growth. This got to be a bubble, as we know in hindsight, but one could see even at that time as the earnings yld got to almost a 5% discount to credit

That is a large premium investors were paying for stocks over bonds. The subsequent 8 years or so saw this premium steadily erode away & then the spread stayed around par going into the GFC

Immediately post GFC, stocks caught a premium again as this asset recovered more quickly, but then from the rest of 2009 thru 2012/13, credit gained the upper hand. At one point credit had a 3% discount to equities, showing the strong investor preference

This preference was for cash flow over growth, it was for the return of capital vs. the return on capital. It was also indicative that many had been burned in the GFC and therefore saw beta in a different mkt

The demand for credit led to not only more ETFs being developed, but the rapid growth of markets like the private credit mkt which works hand in hand with private equity

This credit premium subsided but has hovered around 1% from 2014 to 2022. Toward the end of last year, it collapsed to 0% and then equities regained the upper hand

I will leave it for y'all to decide where this is going. There are long periods of investor preference at play. Is this recent move toward equities the beginning of a multi-year trend favoring growth over cash flow? Or is it a blip ala early 2009?

Where we sit now, the SPX earnings yield is 0.56% lower than Baa yield. If this moves back to par, it is 1.8x turns of P/E. That is about 400 points on SPX so not nothing

My concern is the end of the debt ceiling debate leads to extensive Treasury issuance. This will be soaked up by fixed income investors but lead to higher credit yields. Allocators will switch beta into credit over equities. This means equity gets crowded out & multiples contract

One might argue that this is the positive outcome to the debt ceiling issue. There are uglier outcomes as well. Either way, there is fincl plumbing at work here & nothing nefarious. It is simply the flow of capital

Let me know in the comments your thought on the trend of equity vs. credit. Is AI the catalyst to favor growth over cash flow? Or is this just a blip on the radar?

Stay Vigilant

#markets #investing #stocks #credit #stayvigilant