Corporate Bond Yield Update: Warning – Sell now!

Here’s an update since the last time we looked at earnings yields vs. corporate bond rates.

Since March 2009, the S&P has made a stunning 57% rise from the bottom. Just look at the sharp v-shape in the long-term graph:

However, this isn’t supported by a similar growth in earnings:

This should be enough cause for concern. When we look at corporate bond yields, the situation starts to look a little scarier.

The good news is that corporate bond spreads have narrowed significantly in the last 6 months. BAA bond yields are back to historically low levels (similar to the 2003-2007 period):

This would indicate that there should be an earning yield ceiling of around 6% (which translates to a P/E floor of 16.7). Recall that corporate bond yields were the major driving factor in market prices over the 2003-2007 bull-run, and since there’s absolutely no other positive force in the market today (if anything, everything is much worse), there’s no rational reason for prices to be higher than this floor other than speculation.

The problem is that P/E ratios are currently off-the-charts because earnings have not yet recovered. Trailing 12-months P/E is 138, but that includes the Q4’08 (AIG -$23.25 EPS) quarter. To work around that, I plotted the projected earnings yield above (which uses current quarter EPS x 4). That gives a projected P/E of around 27.

No matter how you slice it, the current P/E is way above the 16.7 floor. By these calculations, the market has room to easily drop by at least 40% at the first whiff of bad news.

More bad news: Look at Sales

Even worse is that sales are still down. According to the S&P:

In case you missed it, that’s a $1.5 Trillion drop in sales. To put that number in perspective, that’s a $5,000 shortfall for every man, woman, and child in the U.S.

As the S&P analyst puts it:

You can only cut so long - eventually you need to increase the top line in order to increase the bottom line
The $1.52T estimated sales decline is almost as much as the Stimulus ($787B) and proposed Health Care ($829B) COMBINED

The bottom line is that the market is acting as if earnings are going to magically double in a short amount of time. This is nothing short of insanity! There is no real hope that this is going to happen. Even if everything goes perfectly, it will be months before a true economic bottom is reached. The short-term danger is that the fed will be forced to continue raising rates to combat the falling dollar. The moment that fully sinks in, the market will experience a sharp crash.

On the bright side, the crazy market has thrown us all an unexpected life-line. If you were underwater 6 months ago, you have probably recovered a lot of your retirement and investment accounts by now. Here’s your golden opportunity to lock that recovery in.

A Lesson from History

Here’s a final data point to think about. This is the Dow Jones Index over the 1929 crash:

Sure, it was a different time with a different set of circumstances, but notice just how sharp that first jump off the bottom in November 1929 was. The market rose from the bottom of 200 in Nov 1929 to 294 in April 1930 (an almost 50% jump). Boy were people optimistic. That over-optimism lasted all of 6 months, before reality finally set in. It would be 25 years before the index recovered to the post-crash peak again.

Full disclosure: I plan to continue exiting out of US equity positions, and buy strategic puts.