Bonds Of Interest To Value Investors

5/11/2015


One of the strongest arguments for buying stocks is their valuation relative to bond yields.

The average stock in the S&P 500 Index trades at 21.5 times trailing earnings, 11% above the five-year average and 13% above the norm for the last decade. But while stocks look pricey relative to their own history on most valuation metrics, bond yields tell a different story.

To compare stocks to bonds, we use the earnings yield, or earnings/price ratio, the inverse of the price/earnings ratio. The lower the P/E, the higher the earnings yield. We also compare dividend yields.

The S&P 500 Index's earnings yield is below 10-year and 50-year averages, no surprise given that P/E ratios exceed historical norms. But earnings yields seem stratospheric compared to bond yields. For example, as of May 5, the S&P 500's earnings yield of 4.9% more than doubled the 10-year Treasury yield of 2.2%, a 120% premium.

Over the last 50 years, the index's earnings yield has averaged a 10% premium to the 10-year Treasury note yield. The 10% average overstates the case, skewed by extremely high premiums in the last few years. Earnings yields have been below Treasury yields 59% of the time over the last 50 years, with the median period showing a discount of 8%.

Purchasing power

The S&P 500's earnings yield has averaged 81% higher than the T-note yield over the last decade and 157% over the last five years. A surge in bond yields has narrowed the premium between earnings yields and T-note yields, but at 120% it remains well above the 10-year average. The same trends have played out between stocks and corporate bonds, though the change in the spread between earnings yields and Baa-rated corporates isn't as dramatic as with Treasurys.

Dividend yields send similar signals. The S&P 500 yields 2.0%, a 12% discount to the Treasury yield and 59% below the Baa-rated bond yield.

Over the last 25 and 50 years, the index's dividend yield has averaged less than half of 10-year Treasury yields. The discount has narrowed over the last decade, and particularly over the last five years. Despite their recent rise, T-note yields are still well below the 10-year average of 3.3% and the 25-year average of 4.9%. The S&P 500's dividend yield has averaged a discount of 29% to Treasury yields over the last decade and 51% over the last 25, suggesting the index's current discount of 12% is unusually small. During the last 600 months, stock-index yields have been that close to Treasury yields less than 6% of the time. The discount between stock yields and corporate yields has also narrowed, though the historical disparity isn't as great as with Treasurys — similar to the earnings yield relationship.

The S&P 500's 1.9% dividend yield is well below the 50-year average of 3.0%, but within spitting distance of the averages for shorter periods. Dividends are growing faster than usual, helped by companies reinstating or accelerating payments in the wake of recessionary cutbacks. However, strong stock returns over the last three years have prevented yields from rising too high.

Dropping anchor

Of course, the cheapness of stocks relative to bonds varies depending on your anchor point. The investment playing field has changed in recent years, so the 50-year average spread may not mean as much going forward.

Based on earnings yield, stocks are also cheap relative to the 25-year average spread, and even the 10-year average. The earnings yield's premium to bond yields has declined in the last five years but remains well above what we saw from 2003 through 2006.

That four-year period is similar to the last five years, in that it covered a stretch of solid economic growth that followed a nasty stock-market decline. The chief difference between the two time periods? The Federal Reserve has held interest rates artificially low since late 2008, which won't last forever.

All else equal, to return the spread between earnings yields and bond yields to 10-year norms, we'd need to see 10-year Treasury yields jump to 2.7% from the current 2.3%, with corporate-bond yields rising to 5.4% from 4.8%. Those moves would also revert the dividend yield-bond yield spread close to the 10-year average. The T-note last yielded 2.7% in April 2014, while Baa-rated bonds haven't yielded 5.4% since late 2013. A return to 25-year norms would require a Treasury yield of 4.2% and a corporate yield of 6.9%, levels not seen since 2008
for Treasurys and 2009 for corporates.

What the numbers mean

Some would argue that with bond yields historically low, we can't take today's massive yield disparities at face value. The argument has some merit, because Fed action to keep short-term rates low has certainly constrained longer-term bonds as well. Bond yields have risen in recent days but probably won't come close to long-run norms until the Fed raises short-term rates. As long as fixed-income yields remain below typical levels, stocks' earnings and dividend yields will look unusually rich, which may provide an edge in competing for investor dollars.

History tells us that at some point, both Treasury and corporate bond yields will rise enough to make stocks seem expensive again. But it probably won't happen overnight. And keep in mind that stock price/earnings ratios could fall if stock prices falter or profit growth picks up. In such a case, bond yields would have to rise even higher to restore spreads to historical norms.

For now, take solace in the table below, which tracks 25 years of stock returns. After periods with earnings yields averaging at least a 100% premium to 10-year Treasury yields, the S&P 500 Index rose an average of 16%, versus a 3% gain after periods with a 20% to 50% premium.

STOCKS DO BEST WHEN CHEAP VERSUS BONDS
Over the last 25 years, we looked at the average 12-month change in the S&P 500 Index after months with different spreads between 10-year Treasury notes and earnings yields or dividend yields.
Earnings Yield Versus
10-Year Treasury Yield
(Number Of Periods)
Avg.
12-Mo.
Chg. In
S&P 500
Index
(%)
Dividend Yield Versus
10-Year Treasury Yield
(Number Of Periods)
Avg.
12-Mo.
Chg. In
S&P 500
Index
(%)
Premium above 100% (35)
16
Premium, or discount up to 10% (28)
22
Premium 50% to 100% (26)
13
Discount 10% to 30% (25)
12
Premium 20% to 50% (101)
3
Discount 30% to 50% (148)
6
Premium 0% to 20% (72)
1
Discount 50% to 70% (324)
9
Discount up to 20% (176)
9
Discount 70% or more (63)
2
Discount 20% to 40% (122)
13
Discount 40% or more (56)
(1)

Where are interest rates heading?

Conventional wisdom holds that bond yields are heading higher, possibly this summer. While convention isn't always right, in this case investors have reason to expect rising rates:

Tiny bond yields. The 10-year Treasury yields 2.23%, lower than only about 4% of the months in the last 50 years. Baa-rated corporate bonds yield 4.77%. Over the last 50 years, corporate bonds have only yielded less in 14 months; nine of those months came during the last 12 months. Interest rates near historic lows are not enough on their own to support the argument that rates will soon rise, but the stage is set.

Economic expansion. Interest rates tend to rise during periods of economic growth, in large part because strong economies tend to drive inflation higher. While the U.S. economy isn't setting records, real gross domestic product has risen at least 1.6% in each of the last four calendar years, averaging a 2.3% increase. The economy slowed to a crawl in the Marchquarter, but the Blue Chip Economic Indicators consensus calls for GDP to recover and rise 2.9% this year.

Stock-market action. The relationship isn't absolute, but when investors become more optimistic about stocks, demand for bonds can falter, which in turn can cause bond prices to fall and rates to rise.

Federal Reserve action. With the fed funds rate near zero since 2008, it has nowhere to go but up. Of course, that's been the case for six-plus years, and the indicators cited above aren't breaking news, either.

Although the timing is uncertain, it seems likely short-term interest rates will rise in the next year, which in turn should boost long-term rates.

 


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