Assessing Equities and Bonds on the Momentum/Valuation Continuum

10.18.2023 “A market in motion tends to stay in motion unless otherwise acted upon” is a useful riff on one of Newton’s laws that is helpful in gauging the direction of financial markets. Momentum, or trend, measures a market’s popularity among investors. Even though momentum, by itself, doesn’t identify attractive markets, when used in combination with valuation it can help to pinpoint attractive entry and exit points. Similarly, valuation by itself is not a timing tool. That’s because cheap markets can stay cheap and expensive markets can keep getting more expensive, staying irrational longer than investors can remain solvent. However, a cheap market paired with positive momentum offers an attractive entry point. Likewise, an expensive market that loses its momentum is a good indicator that it’s probably time to get out. Where does the US equity market fit along the valuation/momentum continuum?

At its current level, the S&P 500 is slightly overvalued when viewed through the lens of bonds. The earnings yield on equities, at 5.1 per cent, trails the 10-year BBB corporate bond 6.3 per cent yield.  Historically, at least before quantitative easing, earnings yield and corporate bond yield moved in lockstep. S&P 500 momentum, however, when measuring the S&P 500’s total return relative to 3-month Treasury Bills, remains positive, suggesting a neutral stance. We use 10 per cent bands around the S&P’s 200-day moving average to analyze this. When the S&P 500 crosses the upper bound it’s a buy signal; when they breach the lower bound, it’s a sell signal. Expensive valuation plus positive momentum implies “hold.”

S&P 500 Index Return Relative to 3-Month US T-Bill Return

Another momentum gauge is comparing the 50-day moving average to the 200-day moving average.  Positive momentum is created when the 50-day moving average crosses above the 200-day moving average; negative momentum is created when it crosses below it. Interest rates are good momentum candidates because they trend with the business cycle. At 4.7 per cent, intermediate-term rates are slightly undervalued since they track longer-term US nominal GDP, which we estimate at 4-4.5 per cent. 

Bloomberg US Treasury Total Return Unhedged USD

A simple model of owning bonds only when their 50-day moving average is above their 200-day moving average would have eliminated most of the downside risk from last year. Momentum went briefly positive earlier this year as bonds rallied, but quickly reversed. Bond momentum went negative in early August and has remained negatively positioned. 

Bloomberg US Treasury Total Return Unhedged US

Bottom Line: The combination of valuation and momentum are useful signals. The S&P 500 is slightly overvalued, so negative momentum would signal risk reduction. We will be watching for the blue-chip index value to fall 10 per cent below its 20-day moving average as our risk-off signal. Bonds are a different matter. Intermediate-term interest rates are slightly undervalued relative to the economy longer term, so a positive momentum signal – in this case, the 50-day moving average crossing above the 200-day moving average – would suggest additional interest rate risk-taking. 

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