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S&P 500 Undervalued Versus Bonds: Deutsche Bank

It looks like the S&P 500 is disconnected from the bond market, which could present a plethora of buying opportunities for investors. But while Deutsche Bank praised the index this week on the back of a multi-day rally, it slumped today following a warning that it could be close to a top.

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Courtesy: Google Finance

S&P 500 tumbles

The S&P 500 fell by more than 1% to as low as 1,924.56 today after posting nice-sized gains last week and Monday. Chart analyst Tom DeMark, who predicted earlier this month that oil would climb, told Bloomberg today that the rally would result in a major slump if it started falling this week. Indeed, it looks like he was right, although it appears as if most of today’s decline came after his comments. The index did start turning early this morning, however.

DeMark said if the S&P 500 slipped at today’s open and drops under 1,917, which was about where it was last week, it could mean that a larger, especially steep slump is just around the corner. He added that if the index ends today under 1,926.82 or Wednesday or Thursday under 1,917, it would be another omen that a steep cliff is coming soon.

The reason the markets are taking his comments so serious is because his chart analysis has resulted in more than one correct prediction earlier this year.

S&P 500 undervalued

Meanwhile Deutsche Bank strategist David Bianco and his team say that the S&P 500 is actually undervalued against bonds. They also said that it looks like the index is disconnected from the bond market and recommend that investors sell Energy but buy everything else.

Specifically, they spoke to concerns about widening credit spreads and that PEs see more downside as debt costs rise. To address these worries, they looked at the yields of all the long-term bonds issued by companies in the index to weigh them against fair PEs across sectors. They said the data they used differs from that used in most credit indices because it only factors in bond yields for companies in the benchmark index.

Upon conducting their analysis, they found that credit spreads look “normal,” excluding Energy, for companies in the S&P 500. Additionally, because of how sharply Treasury yields have fallen, corporate yields are still low. As a result, they believe that Energy stocks are overvalued but that the rest of the index is undervalued against bonds. They said index-consistent bond yields seem to indicate that the index’s PE should be “well over 18,” excluding Energy.

Deutsche Bank: Corporate bond yield at 3.5%

Currently, the Deutsche Bank team says “large S&P firms of solid IG status” can borrow at 3.5% for ten years, which is 175 basis points higher than Treasury yields right now. It’s also slightly higher than the average of 150 basis points over the last three decades. They add that usually the equity cost is 300 to 400 basis points higher than Treasury yields or 200 basis points over cost of debt. As a result, they said history suggests that the nominal cost of equity should be actually at around 5.5%, providing one sign of undervaluation as it supports an “18 PE on normal S&P EPS.”

Looking at individual sectors, they said the average Energy bond among S&P firms has a yield of 6.7%, which places the fair PE at 13. They believe Energy is at 15 times expected earnings with oil at $60 per barrel, which they don’t expect until next year. As a result, Energy stocks look overvalued against their bonds, although they emphasize that it’s important to look at this on a company-specific level before ruling either way.

They think Health Care and Tech stocks are the most undervalued against their bonds. Here’s a brief glance at their sector-by-sector analysis:

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