Stocks v. Bonds: Who’s Right?
Stocks and bonds have been through six years of remarkable harmony. Rising stock prices accompanies higher bond yields, and the two hung together on the downside as well. But they’ve sharply parted company over the past few months; stocks are up 15% while bond yields have dropped one-half percent. And though the two don’t necessarily have to move in tandem, this discrepancy seems based on inconsistent perceptions—which means that a reconciliation is probably at hand.
Perhaps more than anything else, the bond market (we’re talking risk-free Treasuries here, though the story is only slightly different for Corporate bonds) is smitten with deflation. Even though deflation hasn’t occurred in America, inflation has been tame, and contemporary examples of deflation in China and Japan seem to be weighing on investor sentiments. After all, Japanese bond investors now receive yields of 1%, which makes today’s Treasury yields around 3.5% look positively lucrative by comparison. Recent comments from the Federal Reserve about lower inflation being “unwelcome” have also somehow translated in the popular financial press to a substantial risk of deflation—which is surely not what those officials really had in mind.
The deflation fixation also seems to have diverted bond investors’ attention from other prospective developments. For one, bond yields are notoriously cyclical, which means they rise with economic growth and visa-versa. And given that 52 of the 54 forecasters polled by a recent Wall Street Journal survey are predicting a pick-up over the next year, the odds of that happening seem pretty good. Also overlooked is the government deficit situation, which is going from bad to worse. Even 0ptimistic forecasts now predict persistently large budget deficits, and there’s virtual agreement amongst economists that interest rates rise when the public sector increasingly competes for limited funds.
Equity investors, in contrast, seem acutely aware of our position in the business cycle. In particular, corporate profit margins predictably widen in the aftermath of recession, as past layoffs and cost-reduction efforts cause revenue gains to flow disproportionately through to profits. If the last recession ended late in 2001—as increasingly seems likely—we’ve yet to enjoy the best moment of this cyclical earnings rebound.
But what about valuation, one might ask—aren’t stocks still expensive? Hardly. The S&P 500 index is now trading around 22 times what analysts expect those companies to earn this year. While that’s admittedly higher than the past 50-year average of 16, two additional considerations are worth keeping in mind. First. Low interest rates have historically supported higher multiples, and even if long-term interest rates rise a full percentage point from today’s lows, that would still be historically consistent with an earnings multiple of 19. Second, the recently legislated capital gains and dividends tax cuts increased the after-tax return on equities by 20%, which bumps that 19 up to around 23. Hence, even if interest rates rise a bit, stocks still look fairly valued.
So who’s right? The answer depends on one’s outlook. But if you agree with the majority of us Wall Street Journal participants in expecting growth to accelerate (by the way, not one expected deflation), rising stock prices make more sense than falling bond yields.
