Low Bond Yields Key Debate


The Dow Industrials and Dow Transports are near two-month highs, reflecting a solid earnings-reporting season and continued improvement in European debt markets. After this week’s upgrades and downgrades, the Focus List and Buy List have 25% in Vanguard Short-Term Investment-Grade ($10.82; VFSTX). The Long-Term Buy List has 28.7% in this relatively low-risk bond fund.

Bonds versus stocks

When both bulls and bears point to the same thing, investors should take a closer look. Such is the case with yields on 10-year Treasury bonds, which have dropped close to 15-month lows. Bulls argue that stocks are cheap relative to bond yields.

Using the past four quarters of operating earnings, the S&P 500 Index trades at a price/earnings ratio of roughly 15 — close to the low since 1995 but in line with long-term norms. Equivalently, the S&P 500 Index has an earnings/price ratio, or earnings yield, of 6.5%. Based on the spread between this earnings yield and the yield on 10-year Treasury bonds, the S&P 500 Index is as cheap as it has been in about 30 years.

Using S&P 500 cash flow or free cash flow instead of earnings, relative valuations still favor stocks. Consider the cash-flow and capital-spending charts on the right, which show rolling 12-month totals for nonutility and nonfinancial members of the S&P 500. As shown in the charts below, total cash from operations was approaching precrash levels by the March quarter. Because of declining capital spending, free cash flow was well above precrash levels.

Bears argue that backward-looking comparisons between stocks and bonds are misleading, with most such criticisms falling into one of two camps:

Bond yields are low because investors are worried about the risk of deflation, or persistently falling prices. Because deflation is very tough on profits and tends to compress price/earnings ratios, bears argue, stocks are not as cheap as they appear.

Stocks may be cheap relative to bonds, but bonds are massively overpriced. According to this view, we are seeing a mania in bonds, triggered by the Federal Reserve’s policy of keeping interest rates near 0% on money-market instruments. Once the pace of bond-fund inflows slow, argue the bears, bond yields will jump and stocks won’t look so cheap by comparison.


Recent market action has been somewhat encouraging, and we expect stocks to outperform bonds substantially over the next five to 10 years. But, reflecting the sloppy action of the averages since April, we’re holding 25% to 30% of our equity portfolios in a short-term bond fund.

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