Stocks Look Cheap Relative to Bonds

Earlier this week, something unusual happened: The S&P 500 index’s yield was greater than the yield on 30-year Treasury bonds. CNBC, citing data from Bespoke Investment Group, said such an inversion has only happened once before during the past four decades. The only other time was in March 2009. (As of this afternoon, the S&P 500 continues to challenge the 30-year bond on the yield front. Their respective yields are 2.00% versus 1.97%.)

The comparison shows stocks being cheap relative to long-dated Treasury bonds. For the same approximate yield, an investor can get both potential growth of dividends and the lower tax rate levied on stocks. Put another way, investors aren’t paying a higher yield-based valuation to get more potential upside.

One problem with relative yields is that they don’t tell you anything about the underlying prices or absolute valuations. An Audi SUV may be priced relatively less than a comparable Jaguar SUV, but neither vehicle is cheap. Similarly, just because one investment option has a lower valuation than another doesn’t make it a bargain. Relative valuation is merely a comparison of two more assets or securities.

Comparing stocks to bonds isn’t an apples-to-apples comparison either; stocks and bonds are two different things. Stocks provide the opportunity for capital appreciation. Bonds provide the opportunity for capital preservation. Buying and holding Treasury bonds—especially at current yields—is not the path to great wealth but you will get a series of highly predictable cash flows. Stocks have more potential for price appreciation and dividend growth, albeit with a greater risk of falling in price and/or cutting their dividends. There is a reason why bonds are often described as giving investors the confidence to buy stocks.

Nonetheless, there has been a historical precedent for making the comparison. The equity risk premium is the extra return an investor can reasonably expect for holding stocks instead of a risk-free asset. When stocks appear cheap relative to bonds (particularly Treasury bonds), the premium is wider. When stocks appear expensive relative to bonds, the premium is smaller. Yield comparisons give you a quick off-the-cuff method of calculating the premium.

Right now, they are favoring stocks. Here’s what Sam Stovall, CFRA chief investment strategist, wrote in a report that, coincidently, appeared in my email as I was writing this week’s commentary yesterday afternoon: “Since World War II, whenever the S&P 500’s month-end yield exceeded the yield of the 10-year note, the S&P 500 was higher 12 months later by an average 22% and gained in price in 74% of all 31 observations. What’s more, in the 20 times that the 500’s yield bested the 30-year’s, stocks were higher by 12% and rose 80% of the time.”

Despite the favorable track record for stocks when their yields are higher than Treasury bonds and the current low interest rates, a strong argument can still be made for holding bonds. Bonds provide a ballast against the price volatility of stocks. The risk-free nature of Treasury bonds (the U.S. government always pays its bondholders) and low default risk of other high-quality, investment-grade bonds provides certainty of cash flows. Plus, stocks haven’t gone on to rise in price every time the S&P 500’s yield has exceeded the 30-year Treasury bond, as Stovall’s data shows. To the extent your allocation strategy and financial situation calls for maintaining bond exposure, continue to do so. Just lower your expectations for the level of income you will receive from new bonds purchased at current yields or from traditional bond funds.