What the Bond Rally Means for Stocks

Comparing bonds and stocks is crucial for investors.  Here is a good current lesson

Bespoke Investment Group does a great job of analyzing trends and historical results.  Co-Founder Paul Hickey was featured today on CNBC.  As usual, he had some great observations.  Without disparaging the other guests, I would like to focus on the hard data he presented.

Paul noted that bonds had rallied 10% in four months.  This has happened 14 times in the past and the S&P 500 has been up about 15% on thirteen out of fourteen times.  If you add in the combined effect of the stock decline and the bond rally, there are only four occasions and the rally (in all cases) becomes 25%.

Here is the entire interview.  Paul's key comments start at about the 3:30 mark.

Paul's key point is one that a few others are noting — the relative valuation of stocks and bonds.

Stocks versus Bonds

Many large players constantly review asset allocation among major investment categories.  The forward earnings yield of stocks (perhaps adjusted for some skepticism) is constantly compared to bond yields.  I am always surprised when I learn that someone who is basically an equity investor is unaware of the potential yield from alternatives.

One problem is that the projected yields do not reflect overall interest rate changes.  It is fine to expect 4.5% or so from long-term corporate bonds, but you will have capital losses if interest rates increase.  My analysis suggests that the forward earnings yield of the market has roughly paralleled the rates of lower-grade bonds.  You can "reach for yield" and find something that generates 8.5%.  That looks good on a day when the market is down two percent.

For most investors, it is better to take a longer view.  I find most individual stocks to be more attractive than the corresponding bonds, and the overall stock market more attractive than the overall bond market.  This does not mean that you have to be "all in" like the players in the World Series of Poker.  Most investors are making the opposite mistake.  They are opting for minuscule yields without any attention to long-term growth and inflation.

Meanwhile, most investors are doing the opposite.  They see yield as some sort of guarantee while worrying about the risk in stocks.

Investment Conclusion

I wish that more people could have heard the highlighted CNBC segment.  It seems like the dramatic predictions — Dow 5000, Dow 1000, the "New Normal — get all of the attention.  Not a week goes by without a message from someone who is worried about a market collapse.  It is an imbalance of writing, media coverage, and commentary.  Most people would do well to consider the likelihood of Dow 20K.  A recent CNBC poll found a third of their audience predicting that the market would NEVER reach Dow 12,000.  A generation of investors is missing on a chance to own a share of America.  It has become fashionable to be negative.

By contrast, take a look at an excellent article by James Altucher.  He analyzes trends in earnings, employment, China, and the GDP.  Careful readers will note that he accurately cites data.  He also has a number of stock suggestions which are now on my watch list for analysis.  Meanwhile, the comments section is typical of current feedback for those of us writing on the Internet.  The reader feedback can be directly discouraging to authors, but it also influences editors and those hiring writers.  The comments of a small minority may affect what regular readers get to see.

Comments could be the ultimate sentiment indicator if someone could figure out a good measure.

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  • Liberal Roman August 12, 2010  

    “The reader feedback can be directly discouraging to authors, but it also influences editors and those hiring writers.”
    Really? That must be stupid editors. Any article you read on any news site that allows people to post comments will always be the same: “AAAAAAAAAAAAAAA World is ending! World is ending! Obama is a socialist, communist Nazi! AAAAAAAAAAAA!”
    Don’t the editors get this by now. And it goes beyond politics. Look up some random YouTube video and look at the comments. Almost without exception they will be negative.
    Personallly, I would like to see a trend where comments are disabled. The negative misinformation and noise they create outweighs their value.

  • jeff partlow August 13, 2010  

    Interesting mental exercise — gives us a broader perspective on the market (a good thing).
    My guesstimate: Dow hits 20,000 in 2025. That’s via an achievable average of 5% compound annual growth rate.
    But check this out: The irony is that this is the same year that China will surpass the U.S. with the world’s highest GDP. And their market will have quadrupled in the same period (next 15 years) in which the U.S. market doubled.

  • jeff partlow August 13, 2010  

    Althucher is always interesting, but we need to read him critically as he tends to play fast and loose with the data. For example, he cites “the one quarter ahead forward P/E of the S&P 500 is at 12…” How does he get that? Isn’t the S&P about 1080 and the one quarter ahead operating earnings at $76.91, thus a P/E of 14?
    Fourteen is still a reasonably attractive number, but its not 12.

  • Andrew August 13, 2010  

    Jeff Partlow – You may be looking at the top down versus the bottom up estimates. The bottom up number generates lower P/E.

  • verge August 13, 2010  

    I agree completely that people do not consider the choice between bonds and stocks – and that if bonds are down 10% that chances are (based on what happened in the past) that stocks will go higher.
    I thought that there is a clear formula for calculating whether stocks or bonds are offering the best value. I assume that the formula will take the dividend yields of stock and the yield of bonds in to account (not sure if there are any other components). My point is that it should be quite simple to calculate – which is why I find the comment here http://www.zerohedge.com/article/10-year-under-27-legacy-curve-steepeners-cause-much-pain-yields-imply-stocks-have-75-points- confusing. Specifically : “according to the mid-term chart between 10 Year and stocks, the fair value of stocks is around 1,025, or 75 points lower.” The guys are Zerohedge are saying the market is too high in relation to the bond market while Paul Hickey is saying the the stock market is too low. I am missing something?

  • Jeff Miller August 13, 2010  

    Jeff and others — the latest forward earnings estimates for the S&P 500 (bottoms-up) from Thomson/Reuters are 88.50 for the next four quarters and 92.19 for calendar 2011. The estimates have moved up consistently through this year.
    As you note — it is essential to the comparison.

  • Jack August 14, 2010  

    From a perspective on valuation, comparing earnings yields to bond yields is silly. What this comparison most likely illuminates is the market’s view on inflation. If inflation expectations are high, then bond yields rise relative to the earnings yield as inflation is theoretically neutral to the earnings yield (both future earnings and the discount rate increase). If inflation expecations are low (or deflation is a larger possibility) then bond yields decrease relative to the earnings yield. If you consider the historical relationship between these yields you will find that there is virtually no relationship, which is most likely due to changing expectations for inflation over time. For valuation, consider Tobin’s Q.

  • Jeff August 14, 2010  

    Altucher references the “one quarter ahead” P/E. This means the prior 3 quarters actual plus the next quarter estimate. The Standard & Poor’s website provides the current S&P 500 operating earnings (bottoms up) as follows:
    Q3 2009 $15.78 Actual
    Q4 2009 $17.16 Actual
    Q1 2010 $19.38 Actual
    Q2 2010 $20.95 Estimate
    Total $73.27
    S&P 500 now at 1079.25 divided by $73.27 is a
    P/E of 14.7

  • Jeff August 15, 2010  

    The idea of Dow 20,000 is too big of a concept for most short-sighted investors to fathom. But great investors have an ability to see an even bigger picture. Consider this quote from John Templeton:
    “Before this century is over, the Dow Jones Industrial Average will probably be over one million versus around 10,000 now. So for the long-term, the outlook is tremendously bullish if you buy stocks blindly to keep for a century.”

  • Aristotle August 16, 2010  

    “Before this century is over, the Dow Jones Industrial Average will probably be over one million versus around 10,000 now. So for the long-term, the outlook is tremendously bullish if you buy stocks blindly to keep for a century.”
    I should live so long!
    But seriously, I’m not here to say the sky is falling but…typically the market is worried about inflation. Normally inflation heats up, Fed raises rates, recession hits, rates drop, economy recovers, stocks rise.
    Not this time, the big threat is deflation, hence the Fed rate at zero, so if bonds are rising, yields are dropping, the bond market is expecting deflation. If the recovery picks up steam, rates will increase. It’s not a valid link to say rates drop, stock market off to the races.
    No prediction for the market, simply saying the analogy is not valid in this situation.

  • acme76 August 17, 2010  

    You lost me at James Altucher. Never in past decade has James ever been a bit bearish. He himself proclaims permabull – while permabulls have nothing to show for last 13 years. All these metrics are meaningless if market does not care about them. and It does not. There may eb a super bull market in next decade who knows, better wait for it than getting chopped up.

  • John August 18, 2010  

    The question is how do you measure the PE ratio? Wall Street analysts have become looser and looser with accounting standards. They love to ignore the so-called “one-time” write offs and remove them from earnings. Neat trick.
    I prefer a purer version of PE ratio like Shiller’s 10 year.

  • John August 18, 2010  

    One question I would love to have answered: Which asset class is more broadly held in the US by individual investors and institutional investors, stocks or bonds?
    I having researched the numbers recently but I’m betting it’s stocks. So, with the average American leveraged to the hilt at 126% debt, who’s going to buy stocks up 20,000 on the Dow?
    Worse, have you seen the numbers relating to debt that Kyle Bass posted from around the planet? Maybe he’s off a bit but it’s something like $30K per person on planet.
    This amount of debt doesn’t rate to keep expanding…

  • Mike C August 18, 2010  

    Listen to Gary Kaminsky comments starting at 1:45 and follow up discussion with Kyle Bass, extremely successful hedge fund manager

  • penny stocks December 23, 2010  

    Inflation expectations are high, then bond yields rise relative to the earnings yield as inflation is theoretically neutral to the earnings yield. If inflation expectations are low then bond yields decrease relative to the earnings yield.