Equity investors cannot ignore this “alert” from the bond markets

Hello, reader.

Tom Yeung here with today’s Smart money.

When most people start cooking, it’s easy to assume that fancy cookbooks will be a guiding light in making tasty, picture-perfect meals.

But as any seasoned cook—whether at home or in a fancy restaurant—will tell you, the real magic happens when you watch a family member whip up a cherished recipe from memory.

Well, this similar principle applies to the simple but specialized work of analyzing companies.

When I started working on Wall Street as a stock analyst, I was typically given two sets of reports for each company we covered…

Stock sale reports. From investment banks like UBS and Goldman Sachs, focusing on company value stock. These reports covered areas such as share price targets, earnings forecasts and the company’s outlook. (Here’s a sample of one.)

Credit reports. These reports focused on debt of a company and were produced by firms such as Moody’s and Fitch Ratings. They were more interested in a company’s creditworthiness and rated a firm’s bonds on a scale from AAA to C/D.

Now, you might think that equity ratios would be more useful.

That’s because years of study prove that equity is the top layer of a company’s value. If a $100 million company is split 50-50 between equity and debt, every additional $1 million in value goes directly to equity.

For example, if the value of the company increases by $1 million, equity would increase to $51 million, while debt remains at $50 million. Conversely, if the value of the company falls by $1 million, then the value of equity suffers, falling to $49 million, while debt maintains its value of $50 million.

Our theoretical firm would need to lose $50 million in enterprise value before the debt is affected! So one might imagine that stock analysts would be more sensitive to changes in a company’s value and would provide a fellow junior stock analyst with the necessary information.

However, I quickly learned that the opposite is true…

Debt Markets Say ‘Buy’

In my experience, selling companies like UBS and Goldman were ever too bullish. They would paint the rosiest picture, claiming unlimited upside and zero risk and saying “buy, buy, buy!” With many of these investment banks as accountants for the companies they covered, their unspoken job was to be optimistic about selling more stock.

The “Chinese walls” between equity research and investment banking have rarely been enforced.

Meanwhile, debt rating agencies like Moody’s and Fitch would do so consistent publish accurate reports on the health of a company.

This accuracy results from the greater financial liability of credit rating agencies for glaring errors that mislead investors and are therefore less motivated to promote troubled firms. Business is more interested in return of investment, not profitability on investment.

Equity postings allow debt analysts to have a clearer view of the markets. Enron’s problems in the early 2000s, for example, were flagged by S&P and Fitch long before equity analysts turned on the high-priced firm.

This predictive ability extends to debt mARKETS also. Since 1960, each the recession was predicted by a certain occurrence in the debt markets, and this unusual event only gave a false positive during that period. 2022 to 2024 would mark the second false positive.

Meanwhile, the stock markets are far too troublesome to predict much. During that same period, the S&P 500 has seen 18 years of a bear market (prices down >20%) and another 20 years of a correction (prices down 10%-20%).

That’s why one particular event in the debt markets last week is so notable.

Last Friday, the 10-year Treasury yield rose above the 2-year yield for the first time in over two years. This “disinversion” (or inversion) of the spread is a extremely bullish sign as it reverses the yield inversion we have seen since June 2022 – a typical warning of a coming recession. Friday’s “disinvestment” means the recession alarm has now been raised.

It also happens to be the same “special appearance” I wrote about earlier. As recessions approach, the yield on 2-year bonds tends to rise above that of 10-year bonds; debt investors anticipate short-term interest rate cuts and make their bets accordingly. As the risk fades, those same traders then reverse those bets, pushing long-term bond yields back to where they started.

That’s great news for stocks, especially those exposed to the business cycle. Robust economies signal strong employment, mild inflation and rising stock markets. Last week’s reversal is an echo of the late 1990s, which saw a stock market boom (and a tech stock bubble) through 2001.

And so, we remain extremely bullish on our commodity bets in Fry’s Investment Reportand even more so on those that revert to the mean in technology and healthcare. These low price-to-earnings companies benefit as P/E ratios rise and earnings catch up – a couple of lucky breaks. It also avoids the kind of bubble-like actions that turned the dot-com boom into a bust.

This is also why we consciously minimize the recent downward movements of the equity markets.

This does not change our macro perspective. We believe that AI stocks were simply too expensive to start with, which is why Eric has recommended his paid members take profits in some notable tech firms over the past few months. Investment report (go here to find out how to join them).

Lower stock values ​​now provide a more attractive entry point into companies whose outlooks haven’t, frankly, changed by the magnitude that stock prices suggest. Sometimes the most valuable information comes from humble sources, just like the performance nature of your grandmother’s trusty chicken noodle soup.

Sincerely,

Thomas Yeung

market analyst, InvestorPlace