This is the year of the improbable, a BCA Research piece points out. The United Kingdom voted to leave the European Union. Donald Trump is in fact the Republican presidential nominee and is close to Clinton in the polls. The unlikely underdog Leicester City soccer team won the English Premier League. Perenial loser Chicago Cubs remain the odds on favorite to win baseball’s World Series in 2016. And the stock market is rallying to fairy tale levels, based on valuation relative to bonds.
Bond prices determine the relative risk premium investors should expect to receive from stocks
Stock and bond markets have always been correlated at a fundamental if not technical level.
Fundamental value investors consider stock market pricing and anticipated returns in a relative light. Developed government treasuries, typically considered the most secure and lowest risk investment, had a lower expected return than stocks. Stocks were typically a multiple higher due to a risk premium adjustment.
For BCA, over the long term an investment is easier to evaluate because the purchase price is the clearest indicator. At these levels, stocks might be priced high. This fundamental outlook will eventually be realized, it’s just a matter of when.
For valuation levels to remain consistent, equity risk premium paid to investors needs to move to 5.5% — resulting in a 20% loss of stock market value
The equity risk premium offered to investors needs to move near 5.5%, which BCA cites as its multi-century average. The report did not address the relevancy of valuations coming from the 1800’s relative to that in the 2000’s.
Nonetheless, stocks need to move up from their current low equity risk premium of 3.7%, and this could mean pain for investors. In order to arrive at that level, BCA estimates stock valuations will need to come down by one fifth. With the S&P 500 index trading near 2160 today, that would put the market near 1730.
This projection assumes that bond yields remain near current all-time low levels. If the investment return paid to bonds, with little assigned risk, then the risk premium investors should expect from stocks should climb on a relative basis. In other words, as bond yields rise stocks would need to fall in price to remain competitive.
Looking ahead, Brexit vote could bind Europe closer while BCA recommends UK homebuilders over Euro Stoxx 600 in a long UK real estate short EU stocks play
Looking at today’s markets, BCA thinks the Brexit vote could be a surprise that actually binds the Eurozone closer together. The Eurozone break-up probability, as determined by five-year bond spreads, is at .2. The height of Eurozone break-up concerns occurred in 2012 when those spread levels was near .9 before quickly falling to the .1 level in 2014.
In this type of market, where summer winds take minds off the trading desk, equity rallies are possible in the face of clear overvaluation. From BCA’s point of view, such rallies might be multi-week or at best multi-month affairs. But the summer relationship should have clear defined exit points.
The plays BCA recommends in this environment is a relative value play based on unity. Underweight German bunds, currently trading at negative rates, and overweight Spanish Bonos, which benefit from the EU staying together.
Other trades the research firm recommends are long UK homebuilders and short the Eurostoxx 600, which appears to be a buy UK sell EU play to some degree. They recommend long UK clothing and accessories stocks, but then also recommend a long CAC 40 short FTSE 100 in a buy France sell UK relative value stock trade. They maintain a short equities position through the MSCI World index among other trades.