Lehman Bankruptcy Haunts Stocks With S&P 500 Cheapest to Bonds
2009-05-25 23:01:00.9 GMT

By Michael Tsang and Lynn Thomasson
     May 26 (Bloomberg) -- By almost any measure, credit markets have recovered most of the losses caused by September’s collapse of Lehman Brothers Holdings Inc. Not U.S. stocks.
     The Standard & Poor’s 500 Index, while up 31 percent from its lows, must rise 41 percent to reach its last closing price before Sept. 15, when Lehman filed for the biggest bankruptcy in history, freezing financial markets. Since then, 10-year Treasury notes have climbed 4.6 percent and investment-grade company bonds, which plunged as much as 14 percent, are now down
1.2 percent, according to Merrill Lynch & Co. bond indexes.
     The disparity shows that while the U.S. government succeeded in calming markets, stock investors aren’t convinced that the economy and profits will grow fast enough to sustain a bigger advance. Investors are paying the lowest prices on record for equities compared with corporate bonds, based on the earnings yield on the S&P 500.
     “Equity investors are still scarred,” said James Dunigan, chief investment officer at PNC Financial Services Group Inc.’s wealth-management unit, which oversees $96 billion in Philadelphia. “Those scars aren’t as easy to heal as they are in the fixed-income market.”
     Earnings yield, calculated by dividing the total profit of companies in the S&P 500 by the index’s price, equaled 8.2 percent last week, based on analysts’ earnings estimates for next year. That exceeded yields on U.S. investment-grade bonds by 1.36 percentage points, the widest margin on record when compared with historic profits, monthly data compiled by Bloomberg and Merrill Lynch show.

                       Stocks Versus Bonds

     A stock that pays more in earnings than corporate bonds yield in interest is judged to be cheap by some investors who view profits as the main gauge of returns in equities. Comparing earnings yields to bond payments is a valuation technique used by Warren Buffett, the chairman and chief executive officer of Omaha, Nebraska-based Berkshire Hathaway Inc. and the world’s most successful investor.
     Stocks have become even cheaper than debt during the S&P 500’s two-month rebound as corporate bond yields fell by 1.5 percentage points. The gap has widened 0.15 percentage point since the start of March, data compiled by Bloomberg and New York-based Merrill show.
     The S&P 500 also trades below its average price-earnings ratio of 16.3 over the past 128 years, the period tracked by Yale University professor Robert Shiller. Based on analysts’ estimates for combined earnings of $72.59 per share for S&P 500 companies next year, the measure would have to increase 33 percent to 1,183.22 to match the historic valuation, according to share-weighted data compiled by Bloomberg.

                          Lehman, Libor

     Unraveling credit markets sparked by the collapse of bonds tied to subprime mortgages triggered bank losses that have grown to almost $1.5 trillion, causing the economy to contract by more than 6 percent in each of the last two quarters, the most since 1958, Bloomberg data show. The recession deepened when New York- based Lehman, then the fourth-biggest securities firm, filed for bankruptcy.
     Banks hoarded cash on concern more lenders would fail, causing the London interbank offered rate that banks charge each other for overnight loans to more than triple in a month, while the interest for 3-month loans jumped 71 percent. The difference between Libor and the Federal Reserve’s target rate for overnight lending among financial institutions climbed to 3.32 percent on Oct. 10, the highest since at least 1984.
     Investment-grade U.S. corporate debt fell 6.8 percent last year, high-yield bonds lost 26 percent and the S&P 500 plunged
37 percent, including dividends. Ten-year Treasuries returned 20 percent. Securities rated below BBB- by S&P or Baa3 by Moody’s Investors Service are considered below investment grade.

                        Spring Awakening

     The turnaround in equities started in March as the U.S.government and the Fed pledged $12.8 trillion to end the recession and the nation’s three largest banks said they made money at the start of the year. The S&P 500, which reached a 12- year low on March 9, rallied as much as 37 percent through May 8 to post the steepest nine-week gain since the 1930s.
     The S&P 500’s advance since March has restored more than $2.4 trillion to the value of U.S. equities, increasing investor confidence that the bear market is over. The price of options used to insure against share declines as measured by the Chicago Board Options Exchange Volatility Index dropped to 28.80 last week, the lowest level since Sept. 12. Since touching an all- time high of 80.86 on Nov. 20, the VIX has tumbled 60 percent as the risk of a collapse of the financial system waned.

                        Birinyi, Leuthold

     Laszlo Birinyi and Steven Leuthold are betting that a rebound in economic growth will propel share prices.
     Birinyi, founder of Westport, Connecticut-based Birinyi Associates Inc., said the S&P 500 may rise to a record 1,700 within three years. Leuthold, who manages the $1.09 billion Leuthold Core Investment Fund that’s beaten 95 percent of its rivals in the last five years, is betting large money-management firms will put more of their assets in stocks in an effort to avoid underperforming the S&P 500.
     “We are in a bull market,” Birinyi said in a May 20 interview on Bloomberg Television. “Both the market and the economy have surprised us significantly.”
     S&P 500 companies beating analysts’ profit forecasts outnumbered those that trailed by more than 2-to-1 last quarter, in part by reducing expenses. Fairfield, Connecticut-based General Electric Co., Motorola Inc. in Schaumburg, Illinois, and Louisville, Kentucky-based Yum! Brands Inc. topped estimates by cutting costs as sales fell at least 8 percent, according to data compiled by Bloomberg.
     Thirty-eight percent of U.S. companies exceeded consensus revenue estimates in the first quarter, while 60 percent trailed projections, data compiled by Bloomberg show.

                      ‘Meaningfully Higher’

     During the last three years of the bull market, sales at S&P 500 companies increased at an average quarterly rate of 9.5 percent, about 27 percent faster than analysts expect next year, according to data compiled by Bloomberg.
     “Stock markets don’t like to pay for cost cutting,” said Stephen Wood, senior portfolio strategist at Russell Investments in New York, which oversees $151 billion. “We’re going to need to see earnings improve, not just expectations of government policy, for stock prices to move meaningfully higher.”
     Corporate profits have decreased for seven consecutive quarters, the longest streak since the Great Depression, and will decline for two more before recovering, consensus estimates compiled by Bloomberg show. Earnings among S&P 500 companies are projected to drop 17 percent this year, compared with forecasts for a 4.3 percent gain at the start of 2009.

                      ‘Bandwagon Momentum’

     Fed officials signaled that they’re not convinced signs of stabilization in the U.S. economy will persist, minutes from their April meeting released May 20 show. Former Fed Chairman Alan Greenspan said in an interview with Bloomberg last week that U.S. lenders will need to raise “large” amounts of money.
     The S&P 500, which advanced 0.5 percent last week, has slumped 4.5 percent since reaching a four-month high of 929.23 on May 8. The index rose last week after companies from Mooresville, North Carolina-based Lowe’s Cos. to Sears Holdings Corp. in Hoffman Estates, Illinois, beat earnings projections.
     “There was a bit of a bandwagon momentum to the recovery thesis,” said Richard Batty, global investment strategist at Standard Life Investments in Edinburgh, which oversees $184 billion and favors corporate bonds. “We haven’t seen sustainable evidence things have turned strongly enough to want to move our asset allocation beyond yield.”

                         Credit Unlocked

     Credit markets unlocked after the Treasury said it would finance as much as $1 trillion in purchases of banks’ distressed assets, the Fed pledged to buy more than $1 trillion of bonds and the Federal Deposit Insurance Corp. agreed to guarantee some corporate debt.
     The Libor-OIS spread, which measures banks’ reluctance to lend, has narrowed to 45 basis points, or 0.45 percentage point, the lowest level in almost 16 months. It widened to a record 364 basis points in October following Lehman’s failure.
     An index of credit-default swaps linked to bonds of 125 U.S. and Canadian companies fell to 147 basis points, according to CMA DataVision. On Sept. 12, it was at 152 basis points. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equal to $1,000.
     From its peak in October 2007 to its 12-year low in March, the S&P 500 lost 55 percent, including reinvested dividends.
     The discrepancy between bonds and shares is biggest in financial companies that were bailed out by the government. A Merrill index of Fannie Mae benchmark notes returned 6.6 percent from the last trading day before the U.S. seized the mortgage- finance company on Sept. 7. Shares of the Washington-based firm tumbled 89 percent.
     “The big news in the credit markets was the intervention of the Fed,” said Frederic Dickson, the chief market strategist at Great Falls, Montana-based D.A. Davidson & Co., which has $17 billion in client assets. “The stock market was on its own.”