evaluating stocks vs. bonds

In theory, there’s no demand for stocks.  There’s also no demand for bonds.  There is, however, a demand for liquid forms of saving, a category that includes stocks, bonds and cash.

Each of us will choose a basket containing a somewhat different proportion of the three, depending on factors like age, wealth and risk tolerance.  But for all of us, a change in price of any of the three will probably persuade us to shift away from the more expensive investments and toward the now-cheaper one.

Given that the Fed has been signalling for some time that a rise in interest rates–meaning a change in the price of cash–is on tap for next year, the question of how this will affect the price of the other two, bonds and stocks, is probably the most important near-term investment issue for you and me.

One way of starting to look at this issue is to look at what the current price relationship between stocks and bonds is.  The typical way this is done is to compare the interest yield on Treasuries (either the 10-year or the 30-year) with the inverse of the PE on a market index like the S&P (academics call 1/PE the “earnings yield,” because it measures the portion of total profits that each share has a claim to, divided by the share price).

Over my investment career, Wall Street has taken stocks and bonds to be at roughly equivalent value when the interest yield = earnings yield.  (During the 1950s bonds traded at a considerable premium; during the Great Depression, dividend yields exceeded coupon payments on bonds.  But I don;t think either period is relevant today.)

As I’m writing this, the S&P 500 stands at about 1930.  EPS for the index in 2014 will probably come in at about $110.  Thus, the PE of the market on 2014 earnings is about 17.5x.  This means the earnings yield is 5.7%.

EPS for the S&P in 2015 will likely rise to $125+, implying a market PE of 15.4x and an earnings yield of 6.5%.

In other words, the S&P already seems to be discounting a 250 bp increase in the yield on the 30-year Treasury.  Arguably, this is more than the long bond yield is likely to rise in the coming normalization of interest rates by the Fed.

I don’t think this guarantees that stocks will have smooth sailing throughout the interest rise process.  But I do think it argues against the idea that stocks will either mirror the fall in bond prices–or simply collapse.  During the Great Recession and the subsequent recovery, equity investors badly underestimated the severity and the duration of the downturn.  As a result, Wall Street was always on guard against the possibility of imminent interest rate rises.  It never fully discounted the actual interest rate lows–something that will serve stocks well during the normalization process.

Two other points:

–this stock market behavior is not that unusual.  In past periods of Fed tightening, stocks have gone sideways to up.

–on my Current Market Tactics page, I wrote last month that I thought the market stall we’re in now is purely based on valuation and not on worries about rising interest rates.  If that were wrong, the first place to look for deterioration would be in income-oriented stocks, which are in effect quasi-bonds.



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