JULY 31, 2010
By MARK GONGLOFF
Bonds continue to trounce stocks, sending mixed signals to investors and raising the question: Are stocks too cheap or are bonds too expensive?
After consistently lagging behind bond performance this year, stocks appear historically cheap compared with bonds, offering investors reason to favor stocks, particularly if they are optimistic about the economic outlook. But stocks may be cheap because the outlook is dim, meaning bonds—from Treasurys to corporate debt—could continue to outperform for the foreseeable future.
So far this year, the stock market's total return is slightly negative, while normally staid investment-grade corporate bond returns are up nearly 8%, according to Bank of America Merrill Lynch indexes. Even risk-free Treasury returns are up 6%.
Stocks made up some ground with a 7.1% rally in the Dow Jones Industrial Average in July. But such stock rallies have stalled repeatedly in recent months as weak economic data have outweighed signs of hope from corporate earnings. The yield on the 10-year Treasury note has dropped below 3% as investors scramble for safe havens, and the demand for corporate bonds is booming.
One way to compare the relative value of stocks and bonds is to compare their yields, or the amount of cash each asset generates on a regular basis.
Bond yields are easy to see; stock yields are trickier. Many analysts like to use something called an "earnings yield," which is the inverse of a company's price/earnings ratio. While imperfect, earnings yield measures how much cash a company generates for itself and its shareholders as a percentage of its price. As with bonds, higher yields represent lower prices, and vice-versa.
At the end of trading Friday, the earnings yield on the Standard & Poor's 500 index was 6.6%, based on the past four quarters' operating earnings, the highest since 1995.
The gap between that yield and the 10-year Treasury yield—a measure of the cheapness of stocks relative to Treasury bonds—is the widest about 30 years, according to Jason DeSena Trennert, chief investment strategist at Strategas Research Partners.
To Mr. Trennert, this suggests that stocks are too cheap, bonds are too expensive after a strong rally this year, or both.
"People are so risk-averse now that a tremendous potential opportunity is being created in stocks," he said.
He warned, however, that it could take time for that opportunity to be realized, given the high levels of uncertainty about the economic outlook. "The reasons we're seeing this are secular in nature," he said. "They reflect very long-term problems that are not easily fixed."
It isn't exactly surprising for bonds to outperform stocks during a period when stocks are falling. Except for periods of high inflation, corporate bonds, particularly investment-grade, often hold up better in an environment where stocks are falling.
But even last year, when stocks enjoyed one of their most stirring rallies in history, there were at least two long episodes during the bull run when corporate bonds outperformed, according to an analysis by Jason Quinn, co-head of high-grade and high-yield flow trading at Barclays Capital, comparing stock prices to bond yields. In contrast, in the bull market that followed the 2001 recession, stocks outperformed bonds consistently.
In the eyes of stock-market bulls, the underperformance this time around has left corporate bonds expensive and stocks attractively cheap, pricing in dire economic outcomes that most forecasters still don't think likely.
"You would have to believe in at least a mild recession to prefer corporate bonds over equities at this stage," said David Bianco, chief U.S. equity strategist for Bank of America Merrill Lynch.
Mr. Bianco prefers to compare the stock market's earnings yield to the yield on 10-year Treasury Inflation-Protected Securities, as TIPS yields include inflation protection while stock prices and dividend yields do not.
Today, that gap is about six percentage points, compared with about three historically, according to Mr. Bianco—suggesting stocks are underpriced relative to bonds, particularly given how low inflation is.
"I would argue that the asset class with the most upside, even in a scenario of slow growth, is equities," said Mr. Bianco, who has a 12-month target of 1350 for the S&P 500.
The recent outperformance of bonds is also partly a reflection of the fact that individual investors have largely turned their back on stocks after two crushing bear markets and a decade of negative returns.
Despite last year's stock-market rally, one of the best on record, individual investors pulled money from stock mutual funds and poured them into bond funds. The trend has continued this year, with long-term stock funds suffering a net $1.1 billion in outflows and bond funds enjoying $177.6 billion in inflows, according to the Investment Company Institute.
"Investors over the decade of the 2000s were protected by the bond market and beaten up by the stock market," said David Kelly, chief market strategist for J.P. Morgan Funds. "That memory is so powerful in their minds that they'd rather overpay for a bond than underpay for a stock."
Skeptics note that bonds have outperformed stocks partly because economic growth has been too sluggish to help stocks go very far, but not so slow that it pushes companies, many of which are loaded with cash, into default. If such conditions persist as many observers believe, then the stock market could continue to lag behind.
"We could end up with slower growth than people think, and that's not going to be great for the equity market, but it doesn't really matter for credit," said Mr. Quinn of Barclays Capital.
Many skeptics warn that a key difference between this recovery and others where stocks consistently outpaced bonds is the withering of private borrowing and the financial sector, big drivers of recovery in economic and corporate-profit growth in prior expansions.
Private-sector borrowing has shrunk in this recession for the first time since the Great Depression, notes Northern Trust chief economist Paul Kasriel, who in July cut his forecast for annualized economic growth in the second half of 2009 to 1.8% from 2.5%.
He noted that private borrowing continues to contract despite near-zero interest rates from the Federal Reserve. Stimulus is set to fade and unemployment remains high. Under such conditions, borrowing will remain low, and the scarcity of new debt will prop up its value.
"The risk premium in the bond market will increase, but I'm not going to put that bet on now," Northern Trust chief investment officer Bob Browne said in an interview.
from the wall street journal published on JULY 31, 2010