At present, there is much speculation surrounding whether or not the Federal Reserve will engage in another round of quantitative easing and if so, in what size. Recently, stock prices have declinedon worries that quantitative easing will not occur in the size initially assumed, as this article from CBS explains:
World stock markets fell Wednesday amid speculation that the U.S. Federal Reserve‘s stimulus measures will be more modest and gradual than expected.
I note the following chart from Goldman Sachs, which shows that the differential between the earnings yield on the S&P 500 and the yield on the 10yr US Treasury Bond is at its widest level in a generation. I believe that this differential will spur (possibily strong) positive returns for equities in the near future.
Although the stock market is trading above its long-term average P/E multiple of 16.4x, I would argue that in a such a low interest rate environment, investors can justify paying higher earnings multiples for equity investments as the opportunity cost of engaging in such a strategy is much reduced.
In my view these positive stock returns will occur via three mechanisms:
- Investors will move their money from low-yielding money-market funds, government bonds and investment grade bonds into equities, real estate and high yield bonds in order to improve their returns.
- Leveraged investors such as private equity funds and hedge funds will find it advantageous to borrow money at low rates to purchase companies with high earnings/free cash flow yields. We have already been seeing this in action, with a recent recovery in private equity buy-outs.
- Companies will begin to take advantage of low yields to buy-back their own stock or to make takeovers of competitors. Otherwise, they will find net debt reducing/cash balances increasing, further depressing investment grade corporate bond yields and making such actions even more attractive.
These mechanisms, a form of debt-equity arbitrage, will lead to positive equity returns regardless of quantitative easing, in my opinion. All the Federal Reserve has to do is keep short-term rates at their current low levels. The market will take care of the rest. Clearly the risk to this thesis is declining earnings. However, I believe that with sensible active management it is possible to identify companies with stable/growing earnings and high earnings yields to take advantage of this theme.
- Bonds fall on reduced QE2 bets, 5Y auction (reuters.com)
- And Now, Presenting More Proof That Quantitative Easing Doesn’t Work (businessinsider.com)
- What is “Quantitative Easing,” and Why Should We Care? (247wallst.com)
- Investors will earn less than nothing on debt (financialpost.com)