Tuesday, June 17, 2008

Stocks versus Bonds

Yesterday in my reading I ran across this from Bloomberg:
Standard & Poor's 500 Index shares yield 0.2 percentage point more in profits than the interest on 10-year notes, the smallest advantage since 2004, data compiled by Bloomberg show. The last time corporate earnings returned less than bonds, the index posted its biggest monthly decline in five years.
It reminded me of previous research done by Hoisington Investment Management comparing the performance of stocks versus bonds over 10-20 year periods. They looked at the best and worst periods for stocks and bonds and concluded that their relative performances are most affected by three considerations: the inflation rate; dividend yield of stocks versus treasuries; and the P/E ratio. The following chart shows the 4 best and worst periods for stocks and bonds:

Disregard the inflation factor for now (we will look at it again later). Notice though that the difference between the yields on stocks and bonds has been a fairly good indicator of their relative performance into the future. When dividend yields on stocks are much larger than treasuries yields, stocks have tended to outperform over the next decade(s). When the yields between the two converge, bonds have usually outperformed.

Interestingly, the dividend yield in both the best and the worst periods of Hoisington's research was still always higher than the treasury yield. The earnings yield was usually much higher (computed by the inverse of the P/E). According to Bloomberg, the earnings yield today on the S&P500 is just .2 percentage points above the yield of the treasuries. That strongly points in favor of treasuries over the coming decade.

Of course, the Hoisington study says itself that the most important factor of all is the inflation rate. Stock investors benefit from high inflation (relatively), while bond investors prefer benign inflation or even deflation. But predicting the inflation rate has always been a difficulty, and you can get arguments for both inflation and deflation. Yes, gas and food costs are soaring, which is inflationary. But at the same time, the rise in those costs is deterring consumer spending on more elastic goods, meaning less demand, i.e. deflationary.

There is only one thing investors can be sure of- that the relative yields of U.S. treasuries looks very attractive today when compared with the past.

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