Sunday, October 16, 2011

Stocks Versus Bonds

Investors don't consider the attractiveness of the stock market in isolation.  The question at any time is, "What are the investment alternatives, and how much should be allocated to each?"  With the proliferation of new investment instruments, individual investors now have access to investment categories--such as gold, commodities, and real estate--that previously were the realm of only large institutional investors.  So the question has become more complicated by the additional alternatives and the greater difficulty in valuing them.

Today let's consider the two most commonly held asset classes, stocks and bonds.  How attractive are stocks compared to bonds today?  First, consider stocks.  There are various methods for valuing stocks.  I think the best measures are stock prices relative to their long-term norms versus:  long-term (normalized) earnings, cash flow, revenues, and even to national economic output (GDP).  

In valuing stocks relative to bonds, it is common to compare the yield on bonds to the yield on stocks.  But which yield on stocks?  It is straightforward to compare the income yield on bonds to the income (dividend) yield on stocks.  

Mainstream market strategists typically don't compare the income returns on stocks and bonds.  Instead of the dividend yield, they use the stock market's "earnings yield," which is the inverse of the stock market's p/e ratio.  If the p/e of the stock market is 10, for example, then the earnings yield is 1/10 or 10%.  

But strategists usually calculate the p/e by using forecast operating earnings, which historically average about 20% above actual earnings as calculated by Generally Accepted Accounting Principles.  So when earnings are overstated in this way, p/e ratios are understated (and the earnings yield is overstated), making stocks look misleadingly cheap.  (The use of forecast, operating earnings reflects the bias in the financial sector toward stock-market optimism.)  Instead, I prefer using long-term average earnings over the last ten years.  This overcomes the favorable bias toward stocks when earnings and profit margins are at historic high (and perhaps unsustainable) levels.

There is another problem in using the earnings yield as it is commonly promoted.  There is not empirical evidence that supports comparing the earnings yield to the bond yield.  Bull markets in stocks have historically begun when interest rates are high and they move lower, not the reverse.  Yet, when bond yields are low, the earnings yield/bond yield comparison supports buying stocks.  This is a variant of the argument we have often heard over the last decade that "there is no alternative to stocks" because Alan Greenspan and Ben Bernanke drove short-term interest rates (on savings and money market funds) to near zero.  Yet, stocks have returned about zero over the past decade, despite there being "no alternative."  And in Japan, which has had interest rates near zero for the last two decades, stock prices are down about 70% during that time.

Furthermore, the earnings yield is not the actual return on stocks.  The return on a stock consists of its dividend yield plus the growth rate of earnings (and dividends), plus the change in valuation.  The return on a bond is its interest payments plus the change in the market value.  The change in market value is caused by a change in the prevailing market interest rate (and for corporate bonds, a change in the credit rating of the bond).

So how do stocks look now given their historic valuations?  Fairly to attractively valued.  Going back to 1881,  using 10-year average earnings, the current p/e of 19 times would produce an annualized real return (after inflation) of 5.6% over the next ten years.  That compares to 13 times at the market low in March, 2009, but 46 times at the market top in 2000.That is only good enough for the fourth-best quintile of historical experience, however.  Using the S & P 500 Industrial Index price to sales, the S & P is the most attractively valued since the mid 1990's (with the exception of the panic valuation lows of late 2008/early 2009).  The price to cash flow of the S & P Industrials also is the most attractive since the mid 1990's.  Using the dividend yield on the S & P 500, the dividend yield is the highest since the mid 1990's (again, except for the panic market lows of late 2008/early 2009.

When considering bonds in isolation, one should consider the real yield after inflation.  On that basis, current U.S. Treasury bond yields are unattractive, as they are negative after subtracting the latest 3.8% increase in the CPI over the past twelve months.

When comparing stocks to bonds, given the problem of using the earnings yield as the comparison with bond yields, I prefer as a starting point comparing the dividend yield on stocks to the bond yield.  Using this approach, it is not surprising that U.S. Treasury securities are currently unattractive relative to stocks.  Since 1981, the yield on Treasury notes has averaged 2.7 times the dividend yield on stocks.  Yet today, the S & P 500 Index has a dividend yield of 2.15%, which is greater than the 2.10% yield on Treasury notes.  If the ratio would return to the long-term mean, the Treasury yield would rise to 5.8% (or stock prices would rise so that the dividend yield would fall to 0.8%).  Considering long-term Treasury bonds, back to 1926 the mean is 1.7 times the dividend yield.  Today, it is 1.3 times, which is close to the historic norm.

Corporate bonds, whose yields have not fallen as much as those on Treasuries, are now fairly valued relative to stocks.  Since 1926, the Moody's Baa yield has averaged 2.5 times the yield on stocks.  Today, the average bond yield of 5.3% is 2.5 times the dividend yield.

In sum, Treasury securities are unattractive relative to their history and relative to stocks.  Corporate bonds are providing a reasonable yield after inflation.  Stocks are attractively valued relative to the last twenty years and fairly valued over longer period comparisons.

Steve Lehman

S & P 500:  1225

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