Dear Member,
Yesterday, the divided Federal Reserve voted to revive a half-century-old procedure to push down long-term interest rates and make it cheaper for businesses, municipalities and consumers to borrow funds. The Fed announced it would direct $400 billion from the sale of short-term Treasuries to investment in those with maturities of six to 30 years.
The decision came at a time when the yield for the S&P 500 exceeds that of 10-year Treasury bonds. As of Monday morning, the S&P 500 had an indicated dividend yield of 2.13%; 10-year Treasury bond yields were below 2%. (An indicated yield is the sum of expected dividends for the next 12 months divided by the stock’s current price.)
Sam Stovall of Standard & Poor’s pointed out the occurrence, observing, “On a quarter-end basis, this has happened only 20 times since 1953. The good news is that in the following 12 months, the S&P 500 rose by an average 20%. The bad news is that past performance is no guarantee of future results.”
Prior to 1953, the yield situation was reversed. Stocks had higher yields than long-term Treasuries. The chart below, and the yields behind it, can be found on the Historical Market Data spreadsheet in the AAII.com Download Library. (This is the same spreadsheet I mentioned two weeks ago.)
(Click here for a larger image.)
There are a few ways you can look at this data. The first is that long-term Treasuries are not a great value right now. The second is that it makes sense to diversify your bond holdings. Corporate, municipal and foreign bonds can all help you get higher yields without much additional credit risk if you choose wisely. The third is that on a yield basis, large-cap stocks appear to be cheap.
I should point out a few caveats. First, a stock can stay cheap (or expensive) far longer than anyone expects. Second, if the U.S. economy remains in a slow growth mode for an extended period of time, interest rates could stay low. Third, bonds provide return of capital, something that stocks do not. Fourth, stocks offer more potential price return than bonds, so total return should always be considered when looking at stocks. Finally, stock and bond returns have been historically uncorrelated, meaning that diversification benefits can be realized when the two are held in a portfolio.
Thus, there is rationale for owning stocks and owning bonds, even in the current uncertain environment. If you are concerned about the economy, consider a mixture of fewer economically sensitive stocks (consumer staples, utilities, health care, etc.) and more growth-oriented companies (technology, energy, etc.). The idea is that you will lower your risk, but you still have the opportunity to profit should the economy turn out to perform better than you anticipate. On the bond side, you can offset interest rate risk by buying bonds with different maturities and reinvesting the proceeds as each bond matures—a strategy referred as bond laddering. Alternatively, you can buy a diversified bond fund with an intermediate duration (a measure of interest rate sensitivity), such as five years.
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AAII Resources
Dividend Warning Signs Learn how to identify when a dividend is at risk of being cut or eliminated. Balancing Stocks and Bonds Two T. Rowe Price managers explain how they invest for growth and income. Discussion Boards How do you strike a balance between stocks and bonds? Most Popular AAII Articles
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Wishing you prosperity,
