The U.S. stock market is in the midst of a valuation correction. The S&P 500 index topped out on an interim basis at the 2,115 to 2,130 level on a number of occasions between March and July 2015 and has now pulled back as low as the 1,867.61 settlement price on August 25 (a 12.4% correction).
While the specific trigger for the correction cannot be pinpointed, slowing economic growth in China, declining commodity prices, and the prospect of an interest rate hike by the Federal Reserve are among the leading suspects for the broad downdraft in global equity prices.
In terms of market valuation, the 12-month forward price-earnings (PE) ratio for the S&P 500 has now declined to below 16.0x (15.4x and 15.6x 8/25 and 9/28, respectively) from the relatively more expensive 17.5-18.0x readings recorded over the course of the summer of 2015. For perspective the August 25 closing low is just above the brief Ebola-scare market sell-off low of 1,862.49 recorded on October 15, 2014.
Although the current valuation correction in U.S. stocks may be just over one month old, there is another major asset class that is in the midst of a much lengthier and more significant market correction that is also very likely contributing to the recent selling pressure on the stock market.
The U.S. high yield bond market actually established its recovery cycle top over two years ago in January and April 2013 (see chart below). The yield-to-worst associated with the S&P 500 5-7 Year High Yield Corporate Bond Index, calculated by S&P/Dow Jones Indices, reached a low watermark of 3.36% at the end of April 2013, and has subsequently been grinding higher for the past two-plus years. T
he latest leg higher in speculative grade bond market yields has taken the yield-to-worst for this high yield index to a new cycle high of 6.55% as of September 28, nearly double the low watermark level from July 2013. Current yields are equivalent to those last seen in October 2011.
There are valid reasons for the sharp downdraft in speculative grade bond prices witnessed since mid-year 2014, and more recently mid-year 2015 when the yield-to-worst for the S&P 5-7 year high yield index rose to 6.55% from 4.58% as of May 22, 2015.
Sharp declines in demand for, and prices of, global raw materials have placed tremendous downward pressure on anticipated revenue, profitability, and in some cases the debt servicing capacity of energy and materials sector corporations.
While these two sectors constitute only 9.7% of the market capitalization of the S&P 500 equity index, they comprise 21% on the speculative grade corporate bond universe, revealing how the non-investment grade corporate bond asset class is demonstrably more sensitive to developments and potential credit-stress emanating from commodities as an asset class.
For chronological perspective, the current 6.55% yield-to-worst level for the S&P 5-7 Year High Yield Corporate Bond Index, which was last seen towards year-end 2011, would equate approximately to the 1,257.60 2011 year-end close for the S&P 500 stock index. We make this point not to suggest that the stock market should return to levels last seen four years ago, but to highlight how the stock market could still be vulnerable to a further strengthening of the U.S. dollar that imparts additional downward pressure on global commodity prices, which in turn puts additional selling pressure on speculative grade bond prices.
But also be aware that the downtrend in spec-grade bond prices is also now getting a little aged, and based on valuation (especially in the beat-up energy and materials sectors) may actually be in the final stages, or capitulation, of a very elongated correction that commenced far in advance of the relatively young and shallow correction currently underway in the stock market.
We are also reminded of the financial market-vernacular that says, buy-the-rumor/sell-the-fact; which has us wondering whether the U.S. dollar might be close to topping out, and commodity prices bottoming, once the Federal Reserve musters the confidence to initiate the long-awaited normalization of U.S. monetary policy.