Strong equities can only be explained by massive substitution effect from low real rates on bonds and strong beliefs among investors that policy makers will engineer a rebound to come in 2020. But this is a high stake poker play and something we alluded to in our equity update yesterday. US equity valuations are moving into danger zone given the macro backdrop, falling profits and the fallout from potentially higher rates. But maybe everyone outside equities are just wrong and equity investors are right this time. Given equities are a long duration asset class forecasting its returns and valuation is difficult, so don’t be too optimistic on the behalf of equity investors.
Yesterday we talked about the substitution effect from bonds into stocks with robust dividends and price performance. Today we are accompanying this with a chart to illustrate the effect. The shaded areas show periods of significant rise in the among of negative yielding bonds. In both periods, but especially the recent one, minimum volatility stocks have seen their valuation multiples expansion way beyond S&P 500. This is a sign of substitution effect away from bonds and into supposedly safe stocks. However, this substitution effect comes with risk as the move makes the minimum volatility factor trade more crowded and too such an extent that some observers of equity factor returns are sounding the alarm. With US minimum volatility stocks trading at a 29% valuation premium to S&P 500 which trades at a 40% valuation premium to global equities ex. North America you get the picture of just how expensive this segment is.