Buy Stocks, Not Bonds

by: Rupert Hargreaves

The equity market is cheap. By my calculations the market has not been this cheap since 1990, apart from a brief period in 1995; even then the market has not been this cheap for 20 years. This cheap market is occurring even with the Fed's easing operations and this situation is repeated in equity markets all over the world. With these historically low, record-breaking valuations, is now the time to buy equities and sell bonds? High yields in the equity markets certainly present a decent buying opportunity.

We know historically the market is cheap. This is a chart of the S&P 500 average P/E ratio over the last 136 years. The average P/E of the market over this period is around 18, however right now the ratio is significantly lower - around 15.8. Although the average P/E of the market has been somewhat distorted over the past few years through bubble and crashes, a closer look provides a better picture.

The average P/E ratio currently attached to the S&P 500, is the lowest in 10 years, apart from last year's debt crisis. I have highlighted the lows we are at right now. The current average P/E on the S&P is roughly half of the last 10 years' historic average.

Assuming the S&P 500 returned to its historic average P/E of 28, it should be worth approximately 2,500. However removing data that has a variance of more than 30% from the mean (to eliminate market anomalies), the average P/E returns a more respectable 22. This ratio still presents a prospective target of 1,967, still a significant upside from current levels. The current average P/E of just under 16, is still far off these adjusted figures and presents the possibility of a modest move higher. Although a move up to 1,967 could be a little optimistic a move to bring the market closer to historic averages could be expected.

The P/E is not just a market ratio that can be ignored; current EPS are near their highs of 2007, supporting even further market strength. There has been significant EPS growth since the credit crunch and I believe the market is discounting this with commodity prices lower than 2007 as well as consumer spending, the housing market and employment levels all below historic levels. From this I can conclude that if we see a return to 2006/07 spending levels, we could see significantly higher EPS, resulting - if the average P/E ratio remained at these levels - in an even cheaper market.

The fiscal cliff could throw all these ideas off course however. The resulting economic issues from a fall over the cliff would be enough to push ratios down even further - creating unprecedented value within the market. In this scenario there would be a significant reduction in EPS, however right now it looks as if the market could be pricing this in. There is an argument against this scenario however, as with market ratios at record lows - even lower than the credit crisis in 2008 - there is no reason to believe that the fiscal cliff will put the global economy under as much strain as the credit crunch. Effectively I believe this market selling could be overdone and investors are overlooking the bigger picture.

So the market could be cheap but what about Bonds?

One of the best trades over the past few years would have been U.S. treasuries, now down at their all-time lowest yield on a safe-haven trade. Now could be the time to change position with the market, the average yield offered on the S&P 500 is 0.4% above the yield currently offered on the U.S. 10-Year. With the Fed rate currently at 0.25% this gap alone offers a degree of safety above that offered on cash deposits.

A comparison between the U.S. 10-year and the average yield on the S&P 500 - the average yield is higher than that offered on the 10 year. The S&P 500 current average yield is above that of its 10-year mean; however it is significantly below that of the 10-year treasury average yield. With the S&P 500 currently above its historic 10-year yield and the 10-year treasury currently offering less than half of its historic average yield it makes sense to believe that a correction could be due This could come in two ways, either forcing bond yields up eroding investor's capital and subsequently reducing equity yields or, forcing bond yields down, pushing up equity yields and eroding investor's capital.

In reality the equity market is now yielding more than it has done at any point in last 10 years, if we discount the market anomaly in 08/09, where the market crash caused the yields on offer to spike upward.

Sell Bonds.

It is well known that the treasury market right now is offering one of the lowest yields it has in a long time. This low yield modeled over the next 10 years does not show decent investor returns:

Assuming an investor buys a 10-year US treasury today trading at 1.7%, the real returns over the life of the bond will be negative. This model factors in the effect of inflation on the bond and the negative yearly returns this will produce. With 1.7% interest annually, reinvested the investor would see a negative real return of -14% over the life of the bond.

This is not factoring in interest rate changes, which could be sure to happen over the life of the bond.

The 10-year treasury has a Macaulay Duration or effective life of 7.54 years. This produces a $74.14 change in the price of the bond per 1% rise in the rate of interest. Factoring in a minimum of 1% increase in the base rate over the next 10 years, investors would be lucky to see a real return of $803.21 over the 10-year life of the bond.

However if the current loose monetary policy produced increasing inflation, investors could see rates rise 2% or 3% over the life of the bond. This would significantly reduce both real and actual returns of the bond.

The other risk factor in this situation is diversification. Unlike buying a diversified basket of stocks, investing in one asset such as a Treasury can be risky; this is without taking into account the credit worthiness of the U.S. government or the effects of the USD.

If an economic recovery did take place in the next few years, it is assumed bond holders would see a reduction in central bank easing, causing a slight sell-off in bonds, (or a large one depending on government fiscal issue) as the Federal reserve's cash is slowly withdrawn from the market; reducing the sale value of bonds. The economic recovery would also spur interest rate increases, reducing the value of the bond. On the other hand the economic recovery would spur a gain in the market, possibly taking it to previous earnings multiples, improving investor's capital returns.

Buy equities or bonds?

In conclusion equities now are cheap and on offer. They offer a better yield than U.S. treasuries and offer a more diversified investment. On the other hand if you believe the world economy is going to crash tomorrow, then U.S. treasuries could provide a better option, but at current yields they do not provide a decent return and with inflation they will provide negative returns. If there is a recovery U.S. treasuries will not provide decent returns, in fact they will significantly reduce investors' real and actual returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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