Call No. 1: Maintain Long-Term Overweight Global Equities
“Why own stocks in the first place?” Many investors are asking this question in light of the long-term stagnation in global equity markets, recent market volatility and the surprising outperformance by bonds in 2011.
This year so far, U.S. large caps are down around 1% and a broad benchmark of global stocks is down around 10%. At the same time, bonds - as measured by the Barclays Capital US Aggregate Bond Index - are up around 7%.
Despite equities’ poor performance year-to-date, there is a clear long-term case for holding stocks. The argument largely comes down to valuation. As I’ve mentioned in the past, both U.S. and global equities are trading well below their historic averages. In the United States, the S&P 500 is trading at 12.3x trailing earnings. Going back to 1954, this is in the bottom quintile, or lower 20%, of valuation levels.
More importantly, valuations look even cheaper when compared to bonds. A common comparison between stocks and bonds is to look at the earnings yield on stocks - measured by the earnings of an index divided by the price - versus the yield on a bond index. Given that Treasury yields are arguably distorted by the Fed’s quantitative easing program, let’s look at the yield on an index of investment grade bonds. Today, Moody’s BAA Index has a yield of 5.16%, while the earnings yield on the S&P 500 is around 2.5% more. In September, this differential reached 3.1%, the highest level since 1958.
It’s relatively rare that equities yield this much above bonds. Looking at data back to 1954, there were only around 60 months when the spread was this large in favor of equities. This also happened in the mid-1950s, late 1974 and1978. In retrospect, all of these periods represented very attractive long-term entry points to buy stocks.
Today, market conditions are obviously different. Fiscal problems in the United States and Europe are proving difficult to overcome and are almost certain to crop up again in 2012. Of course, one could argue that stocks are cheap now because of a loss of confidence in equities (this was the case in the late 1970s). But even after adjusting for today’s weak consumer confidence, equities still look extremely cheap relative to bonds.
Historically, there has been a tight relationship between consumer confidence and the yield spread between equities and bonds. Since 1991, the level of consumer confidence has explained roughly a third of the variation in the yield spread. When confidence is higher, equity valuations tend to be higher, pushing equities’ yield down relative to bonds. The opposite happens when confidence is low. At today’s yield spread and consumer confidence levels, you would expect large-cap U.S. stocks to be trading at roughly 18x trailing earnings rather than 12.5.
For these reasons, I’m continuing to advocate an overweight to equities, especially for long-term investors concerned with maintaining purchasing power. My preferred way to try to capture this opportunity is through a position in global mega-caps with high dividends (possible iShares solutions: OEF, IOO, DVY, IDV and HDV).
Call No. 2: Overweight Latin America
I already hold an overweight view of Brazilian equities and am closely watching stocks in Chile. Now, as other parts of Latin America, including Mexico, are also looking attractive I’m advocating an overweight view of Latin American equities in general.
Next year, I expect Latin America to post better relative growth than other parts of the world, including other emerging markets outside of Asia. In addition, while inflation was a serious problem in Latin America last year, inflation in the region is now decelerating. Brazilian inflation, for instance, is still above the Central Bank’s target, but it has fallen to 6.6% today from 7.3% in September.
One potential way to access Latin America is through the iShares S&P Latin American 40 Index Fund, the ILF.
Author is long DVY and IOO.
International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise.
Past performance is not indicative of future results.