The valuation argument for holding stocks over bonds is getting stronger. Not only do earnings favor stocks, but so do dividend yields. And if that wasn't enough, yields on the benchmark 10-year Treasury note fell to 1.53% today-the lowest level since at least 1945. (The yield was 1.58% at market close.)
None of this is to say that bond yields can't go lower or stock prices will rise, both could happen. The German 10-year bond yielded 1.21% today and the Japanese 10-year bond was even lower at 0.83%. Yale Professor Robert Shiller's model says the S&P 500 is still expensive with a cyclically adjusted price-earnings ratio of 21.2. (The historical average for Shiller's model is 16.4.)
But financial history says there is a benefit to playing the odds. The odds in finance often favor a reversion to the mean, especially when valuations are out of whack on a historical basis. When one asset class becomes overvalued relative to another asset class, the pricier one tends to depreciate and the cheap one tends to appreciate. Does this always happen? No, but given that soothsaying skills are in short supply and cracked crystal balls are all too common, reversion to the mean is the best long-term oddsmaker we have.
Right now, reversion to the mean says that stocks are cheap and bonds are dear.
Since 1953, yields on the 10-year Treasury have averaged 6.21%. Earnings yields (earnings divided by price-the inverse of the price-earnings ratio) for the S&P 500 have averaged 6.84%. Proponents of earnings yield say the asset with the higher yield is the one that is more attractively valued. Historically, this has been stocks, but not by much. In fact, earnings yields have ranged between +2 and -2 percentage points of the benchmark bond's yield 60% of the time. Based on today's closing price, the earnings yield on the S&P 500 is 8.01%, or 6.43 percentage points higher than the yield on the 10-year bond.
Dividend yields are even more telling. Since 1953, the S&P 500 has had an average dividend yield of 3.26%, about half the historical average yield of the 10-year Treasury. Approximately 90% of the time, dividend yields have been below the benchmark bond yield. The only periods when dividend yields exceeded 10-year Treasury yields were April 1953-August 1958, December 2008-March 2009 and September 2011 through today. Based on today's close, the S&P 500 yields 2.38%, or 80 points higher than the 10-year Treasury note.
Since a picture is often worth a thousand words, here is a chart showing the long-term trends.Click on image for larger view
From a tactical portfolio management standpoint, the numbers argue for overweighting stocks at the expense of bonds. Yet, according to the Investment Company Institute [ICI], many investors are doing the exact opposite. Money has flowed out of domestic equity mutual funds for 14 consecutive weeks. At the same time, money has flowed into bond funds. In other words, mutual fund investors are buying dear and selling cheap, which is not a successful long-term strategy.
Bonds shouldn't be avoided, but from the standpoint of overall portfolio management, their relative valuation needs to be considered. Bonds work great for providing diversification and preservation of capital. Plus, although yields are currently at historically low levels, nobody knows when they will rise or by how much. This said, stocks are the comparatively cheaper asset class and should offer enough upside over the long term to compensate for any downward price volatility that could occur in the foreseeable future.
The historical data discussed above came from our Historical Market Data spreadsheet, which is accessible in the AAII Download Library.
Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.