The Most Alarming Market Metric by Robert R. Johnson

Many analysts are providing commentary on the frothy levels of market valuations. They point, for instance, to the fact that stocks are selling at over 25 times earnings, when measured against the cyclically-adjusted P/E (CAPE). Others point to more obscure metrics like the historically high ratio of the market capitalization of all U.S. equities relative to GDP. I believe that one need look no further than the junk bond market to recognize that something truly is “out of whack.”

Market Metric: Barclays Capital High-Yield Index

The Barclays Capital High-Yield Index is currently yielding less than 5%. To put that in perspective, from 1926 through 2013, data compiled by Ibbotson Associates showed that long-term and intermediate-term U.S. government bonds returned 5.5% and 5.3%, respectively. Investors have become so desperate for yield that they are willing to accept the higher risk of junk bonds to boost the income from their investment portfolios, allowing them to reach their return targets. The expected return from bearing this additional risk is an expected return that is less than the historical long-term return on default-free U.S. government securities.   To quote Lewis Carroll from Alice in Wonderland, “What a strange world we live in…said Alice to the Queen of Hearts.”

Market Metric: Reaching for yield, investors’ biggest mistake

Reaching for yield is one of the biggest mistakes investors make in a low-interest rate environment. They stick to their yield target and invest in higher risk and higher yielding assets in order to meet that target. This is true today as more and more investors are putting money into riskier bonds (particularly high-yield bonds) to provide them with that desired level of income. The recent cash inflows into high-yield bond funds have exceeded nearly every other asset class. A recent Forbes article documented that investors had plowed a staggering $3.2 billion into high-yield bond funds in a nine-week period ended in early July.

It seems that investors are focused only the expected return from the strategy and are minimizing the risk inherent in that class of investments. It would be wise for them to recall that high-yield bonds are, in fact, called junk bonds for a reason.

Robert R. Johnson, Ph.D., CFA, CAIA is a Professor Finance in the Heider College of Business at Creighton University and is also the author of several books including Strategic Value Investing: Practical Techniques of Leading Value Investors.