why look at bonds?
If we’re stock market investors, why are we interested in bonds anyway? It’s because at bottom we’re not really interested in stocks per se. We’re interested in liquid publicly-traded securities–i.e., stocks, bonds and cash. We’re interested in publicly-traded securities because we can almost always sell them in an instant, and because there’s usually enough information available about them that we can make an educated decision.
comparing bonds with stocks
bond yields, at yesterday’s close
One-month Treasury bills = 2.18%
Ten-year Treasury notes = 2.07%
30-year Treasury bonds = 2.57%.
Current dividend yield on the index = 1.7%.
According to Yardeni Research (a reputable firm, but one I chose because it was the first name up in my Google search), index earnings for calendar year 2019 are estimated to be about $166, earning for the coming 12 months, about $176.
Based on this, the S&P at 3000 means a PE ratio of 18.0 for calendar year 2019, and 17.0 for the 12 months ending June 2020.
Inverting those figures, we obtain an “earnings yield,” a number we can use to compare with bond yields–the main difference being that we get bond interest payments in our pockets while our notional share of company managers remains with them.
The 2019 figure earnings yield for the S&P is 5.6%; for the forward 12 months, it’s 5.8%.
During my time in the stock market, there has typically been a relatively stable relationship between the earnings yield and 10-/30-year Treasury yields. (The notable exception was the period just before the 2008-09 recession, when, as I see it, reported financials massively misstated the profitability of banks around the world. So although there was a big mismatch between bond and stock yields, faulty SEC filings made this invisible.)
At present, the earnings yield is more than double the government bond yield. This is very unusual. Perhaps more significant, the yield on the 10-year Treasury is barely above the dividend yield on stocks, a level that, in my experience, is breached only at market bottoms.
Despite the apparently large overvaluation of bonds vs. stocks, there continues to be a steady outflow from US stock mutual funds and into bond funds.
the valuation gap
Using earnings yield vs coupon rationale outlined above, stocks are way cheaper than bonds. How can this be?
–for years, part of world central banks’ efforts to repair the damage done by the financial crisis has been to inject money into circulation by buying government bonds. This has pushed up bond prices/pushed down yields. Private investors have also been acting as arbitrageurs, selling the lowest-yielding bonds and buying the highest (in this case meaning Treasuries). This process compresses yields and lowers them overall.
–large numbers of retiring Baby Boomers are reallocating portfolios away from stocks
–I presume, but don’t know enough about the inner workings of the bond market to be sure, that a significant number of bond professionals are shorting Treasuries and buying riskier, less liquid corporate bonds with the proceeds. This will one day end in tears (think: Long Term Capital), but likely not in the near future.
To the extent that 1 and 3 involve foreigners, who have to buy dollars to get into the game, their activity puts at least some upward pressure on the US currency. The dollar has risen by about 2.4% over the past year on a trade-weighted basis, and by about 3% against the yen and the euro. That’s not much. In fact, I was surprised when calculating these figures how little the dollar has appreciated, given the outcry from the administration and its pressure on the Fed to weaken the dollar by lowering the overnight money rate. (My guess is that our withdrawing from the TPP, tariff wars, and the tarnishing of our image as a democracy have, especially in the Pacific, done much more to damage demand for US goods than the currency.)
high-yielding stocks as a substitute for bonds?
I haven’t done any work, so I really don’t know. I do know a number of fellow investors who have been following this idea for more than five years. So my guess is that there aren’t many undiscovered bargains in this area.
my bottom line
I’m less concerned now about the message low bond yields are sending than I was before I started to write these posts. I still think the valuation mismatch between stocks and bonds will eventually be a problem for both markets. But my guess is that normalization, if that’s the right word, won’t start until the EU begins to repair the serious fissures in its structure. Maybe this is a worry for 2020, maybe not even then.
It seems to me that the US stock market’s main economic concern remains the damage from Mr. Trump’s misguided effort to resuscitate WWII-era industries in the US. The best defense will likely be cloud-oriented cash-generating software-based US multinationals. (see the comments by a former colleague attached to yesterday’s post).
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