Relative Value: Stocks vs. Bonds

Includes: SPY, TLT
by: Surly Trader

The stock versus bond debate has been all the rage in the last few months. The battle can get heated as deflationists battle inflationists. The problem seems to be that they are missing the forest for the trees. Bonds are not magic instruments with built in safety nets. The current yield on a bond generally is very close to what you should expect as the total return for that investment:

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Do you like the current yield of treasuries?

This means that if you want to hold onto bonds, you had better like the current yield to worst of the bonds that you are buying. At a 2.5% 10 year treasury yield and 4% investment grade 10 year corporate yield, I cannot say that I am thrilled with the potential return. As an alternative we have the unloved equity market with a 10% earnings yield. If we want to be skeptical, then let us do some simple historical math comparing investment grade corporate bond yields to current S&P 500 earnings yields:

Do you see an outlier?

Trading and investing are all about relative value. Whether you believe that earnings are going to persist or not, the value proposition in stocks is historically much greater than the value proposition in investment grade bonds. We would have to expect a crushing recession to take away 60% of earnings in order for us to be this stubborn. Why would you buy a 2.5% treasury when you can get 2% in dividends from the S&P 500? Volatility you say? Then sell at-the-money call options and get the yield on stocks up to 6% and greater. Likewise, switch to dividend paying stocks and cover them for a juicy 10% yield. I dare you to find a fixed income alternative that can provide you with greater yields and less long term risk.

Disclosure: Long SPY