AAII Investor Update: Yields Say Stocks Are Cheap

Thursday, May 31, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 28.0%, down 2.5 points
  Neutral: 30.0%, down 0.9 points
  Bearish: 42.0%, up 3.4 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


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The valuation argument for holding stocks over bonds is getting stronger. Not only do earnings favor stocks, but so do dividend yields. And if that wasn’t enough, yields on the benchmark 10-year Treasury note fell to 1.53% today—the lowest level since at least 1945. (The yield was 1.58% at market close.)

None of this is to say that bond yields can’t go lower or stock prices will rise, both could happen. The German 10-year bond yielded 1.21% today and the Japanese 10-year bond was even lower at 0.83%. Yale Professor Robert Shiller’s model says the S&P 500 is still expensive with a cyclically adjusted price-earnings ratio of 21.2. (The historical average for Shiller’s model is 16.4.)

But financial history says there is a benefit to playing the odds. The odds in finance often favor a reversion to the mean, especially when valuations are out of whack on a historical basis. When one asset class becomes overvalued relative to another asset class, the pricier one tends to depreciate and the cheap one tends to appreciate. Does this always happen? No, but given that soothsaying skills are in short supply and cracked crystal balls are all too common, reversion to the mean is the best long-term oddsmaker we have.

Right now, reversion to the mean says that stocks are cheap and bonds are dear.

Since 1953, yields on the 10-year Treasury have averaged 6.21%. Earnings yields (earnings divided by price—the inverse of the price-earnings ratio) for the S&P 500 have averaged 6.84%. Proponents of earnings yield say the asset with the higher yield is the one that is more attractively valued. Historically, this has been stocks, but not by much. In fact, earnings yields have ranged between +2 and -2 percentage points of the benchmark bond’s yield 60% of the time. Based on today’s closing price, the earnings yield on the S&P 500 is 8.01%, or 6.43 percentage points higher than the yield on the 10-year bond.

Dividend yields are even more telling. Since 1953, the S&P 500 has had an average dividend yield of 3.26%, about half the historical average yield of the 10-year Treasury. Approximately 90% of the time, dividend yields have been below the benchmark bond yield. The only periods when dividend yields exceeded 10-year Treasury yields were April 1953–August 1958, December 2008–March 2009 and September 2011 through today. Based on today’s close, the S&P 500 yields 2.38%, or 80 points higher than the 10-year Treasury note.

Since a picture is often worth a thousand words, here is a chart showing the long-term trends.

From a tactical portfolio management standpoint, the numbers argue for overweighting stocks at the expense of bonds. Yet, according to the Investment Company Institute (ICI), many investors are doing the exact opposite. Money has flowed out of domestic equity mutual funds for 14 consecutive weeks. At the same time, money has flowed into bond funds. In other words, mutual fund investors are buying dear and selling cheap, which is not a successful long-term strategy.

Bonds shouldn’t be avoided, but from the standpoint of overall portfolio management, their relative valuation needs to be considered. Bonds work great for providing diversification and preservation of capital. Plus, although yields are currently at historically low levels, nobody knows when they will rise or by how much. This said, stocks are the comparatively cheaper asset class and should offer enough upside over the long term to compensate for any downward price volatility that could occur in the foreseeable future.

More on AAII.com

The Week Ahead

I will speak to our Sacramento chapter on Thursday, June 7, and our Silicon Valley chapter on Saturday, June 9. We have chapters throughout the country, and a list of upcoming meetings for all of them can be seen on the AAII Local Chapters page.

Just four S&P 500 members will announce quarterly results next week. Brown-Forman (BF.B) and Pall Corporation (PLL) will report on Wednesday. Altera (ALTR) and J.M. Smucker (SJM) will report on Thursday.

The week’s first economic report will be April factory orders, which will be published on Monday. Tuesday will feature the ISM’s non-manufacturing survey. The Federal Reserve’s periodic Beige Book and revised first-quarter productivity data will be published on Wednesday. Friday will feature April international trade and April wholesale trade data.

Several Federal Reserve officials will speak publicly next week. Chairman Ben Bernanke will testify before a joint economic committee on Thursday. Chicago President Charles Evans will speak on Tuesday. San Francisco Federal President John Williams will speak on Wednesday. Atlanta President Dennis Lockhart will speak on Wednesday and Thursday. Minneapolis President Narayana Kocherlakota will speak on Thursday and Friday.

AAII Sentiment Survey

Bearish sentiment rebounded to an unusually high level, while bullish sentiment remained at below-average levels in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 2.5 percentage points to 28.0%. This is the ninth consecutive week that optimism has been below its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, declined 0.9% to 30.0%. This is the third consecutive week that neutral sentiment has been slightly below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 3.4 percentage points to 42.0%. This is the seventh time in the past eight weeks that pessimism has been above its historical average of 30%.

The spread between bullish and bearish sentiment, the bull-bear spread, widened to -14 percentage points. This is the third negative double-digit spread in the past four weeks.

Bearish sentiment rebounded back to an unusually high level. This is the third time in the past four weeks, and the fourth out of the last eight, that pessimism has exceeded 41%. Bullish sentiment, on the other hand, is right at the separating point between the typical range of readings and a level that is unusually low.

Individual investors remain concerned about the European sovereign debt crisis, the pace of U.S. economic growth, and the recent downward volatility in stock prices. Underlying this are fears that a repeat of last summer’s correction could occur this year. Also playing a role in hurting sentiment is the lack of positive catalysts.

This week’s special question asked AAII members what they thought about the Facebook (FB) initial public offering. Many respondents said the IPO was overvalued, overhyped or otherwise risky. Some said they were not surprised by the poor performance of the stock, and thought the market was acting in an efficient manner. A few said they were surprised about how the IPO was handled with some going as far as to call the offering a “fiasco”. Others were more critical and opined that the investment industry puts individual investors at disadvantage, especially relative to institutional investors.

Here is a sampling of the responses:

  • “I felt it was overhyped from the beginning.”
  • “There was adequate information regarding Facebook to make an investor wary of the IPO’s outcome.”
  • “It fulfilled my expectations in every respect. I didn’t see Warren Buffett investing in this turkey.”
  • “It was a fiasco that can dampen individual investors’ enthusiasm for IPOs in particular, and the stock market in general.”
  • “It gives further credence to the theory that the market is rigged toward the big-money investors and against regular people.”

» Take the sentiment survey