The question is, stocks or bonds? How do you mix them in this economic and capital market environment? Curiously, in my 30 years of investment industry experience, I have never before seen investors so focused in lopsided fashion on what’s wrong with the economy instead of right. This preponderant attention to the market’s weakness instead of its strength is a natural outcome of 2008, year of the worst economic and social upheaval in more than 70 years. But the U.S. economy is in far better shape than the news would lead one to believe. The current recovery is substantially stronger than the average of the last six post-World War II economic recoveries when industrial production (i.e., manufacturing) is measured, according to Ned Davis Research.
American business has repaired its finances in preparation for the growth cycle ahead. The level of interest payments corporations currently pay on their outstanding debt (when compared with their cash flow) is back to the 64-year average level. The return on equity (earnings per share relative to common and preferred book value) is at a quite handsome 22.3%, far above the 40-year average. As a result, the earnings per share on the S&P 500 index have reached a new all-time high.
Moreover, U.S. corporations are sitting on a record level of cash, $1.73 billion. This gives them the greatest level of liquidity, flexibility and dry powder since the early 1960s. At some point, this cash will be deployed to expand business, hire new workers and make acquisitions. It could be an unusually strong growth cycle. In the meantime, the first green shoots of a business rebound have shown up. Freight shipping rates are a great leading indicator of future economic growth. The Cass Freight Index has been rising since January 1, 2009, at one of its fastest rates in over 32 years. The Small Business Optimism Index has been skyrocketing since the beginning of 2009 at the fastest pace since the recession of 1980. Total online help-wanted advertisements are at an all-time high.
Businesses may be in great shape, but are their stocks fairly valued? The S&P 500 price-to-operating earning ratio is currently at 14.64. This is cheaper than either the 25- or 50-year averages for this ratio. The more diversified Value Line Index sports a P/E ratio of 15.3.
Nevertheless, valuation is not absolute. It’s only relevant when one looks at the alternatives. The ratio of investment-grade corporate bond yields to the yield of S&P 500 GAAP earnings favors stocks more strongly than at any point in over 31 years. A similar relationship is found in junk bonds. The yield on the Barclays Capital U.S. Corporate High Yield Index is below the yield of the S&P 500’s operating earnings. We haven’t seen this in more than 20 years. Stocks appear to be more favorably valued than both investment-grade and high-yield corporate bonds.
With Treasurys, the contrasts become even more extreme.1 Interest rates peaked back in September 1981 and have been falling ever since. From September 30, 1981, through September 1, 2012, the total return on the Barclays Capital U.S.
Treasury Long Bond Index was 11.4% per year. This was the greatest collapse of interest rates in more than 100 years. Of course, what comes down can just as easily go back up. Recall 2009, when interest rates bumped up just a little bit. In that single year, the prices of long Treasury bonds fell 17.1%. Imagine what would eventually happen to Treasury prices during an extended period of rising interest rates such as the one we had in the 1970s and 1980s.
Today, the real yield (yield net of inflation) on long-term Treasurys is the lowest in 30 years. I find it strange that somebody would even consider holding a U.S. Treasury bond. The rational investor can only consider them if he is making an unvarnished bet that our economy is about to fall off the cliff. Currently, more than 55% of the stocks in the S&P 500 index pay a higher dividend yield than one would earn on a 10-year Treasury bond. And unlike the Treasury bond owner, the stockholder can expect rising dividends, and, if he holds on long enough, capital gains. Over the last 12 months, almost 60% of the S&P 500 companies increased their dividend rates. This figure should increase, since corporations are already paying out a record low percentage of their earnings in dividends (the lowest in more than 86 years).
As we all recognize, asset categories appreciate and depreciate for reasons other than the expansion or contraction of the domestic economy. Following the Great Recession of 2008, the Federal Reserve, the U.S. Treasury Department and Congress worked closely together to execute the single greatest economic stimulus program in all of our nation’s history.
This highly coordinated effort to directly inject nitroglycerin into the patient peaked at the end of 2009. Nevertheless, the world’s six largest central banks continue coordinated monetary stimulus efforts. The last round was announced in September 2012 and dubbed QE3. This latest effort is so different from anything that’s been done or even considered before that we are now deep into the writing of new monetary and central bank history. Economic historians will be writing about Fed Chairman Ben Bernanke for the next hundred years.
On top of the banks’ stimulus is a growing body of favorable domestic economic news. Over the last several weeks, we have seen good news about industrial production, consumer confidence, business confidence, retail sales, home builder confidence, housing prices, consumer discretionary spending, automobile sales, shipping, delinquency rates, the declining number of layoffs and bank lending. It would be a daring move indeed to bet against stocks at this instant in time, when the ratio of good news to bad is improving so rapidly and, at the same time, central banks continue to pour money into the markets. Tomorrow may bring a different reality, but until it does, the body of evidence strongly supports overweighting stocks against bonds and removing all Treasurys from any portfolio.
Only the most pessimistic investor could possibly hold Treasurys today.
Rob Brown, Ph.D., CFA, is the chief financial strategist for Eqis Capital Management Inc. You can reach him at firstname.lastname@example.org.