Given market volatility and fears of a double-dip recession, it may not seem surprising that investors have been pouring money into bonds, bidding up prices and driving down yields. Nervous investors have reduced exposure to stocks and other securities with greater perceived risk, even though bonds offer low returns. This flight to safety manifests itself in various ways, including the flow of money into bond mutual funds and the shrinking premiums over Treasurys offered by corporate bonds.
Even if this trend is not surprising in the current market environment, we think investors have it wrong. While we are finding certain bonds offering yields that are high enough to compensate us for the risk inherent in the bonds, these opportunities are currently few and far between. Meanwhile, stocks are trading at attractive valuations and in many cases offer higher yields than those available on bonds.
We noted in our last quarterly report that the earnings yield on the S&P 500 index (earnings/price) was, at the time, more than twice the yield of the 10-year Treasury. This ratio has now increased to nearly three times. Many stocks also offer dividend yields that are greater than the yield on Treasurys, and the dividend yield on the stock of some companies is even greater than the yield on the company’s bonds. These relationships indicate an overvaluation of bonds, an undervaluation of stocks, or some combination of the two.
We believe stocks are undervalued and will offer greater long-term returns than bonds. Several articles stating a similar opinion caught our attention recently, including this opinion piece by Wharton professor Jeremy Siegel and Jeremy Schwartz in Wednesday’s Wall Street Journal and an interview with Siegel in Advisor Perspectives. Both offer a well-reasoned analysis of the current opportunity in stocks within the context of Siegel’s extensive study of market history. Siegel reminds us in the interview, “Don’t forget valuations,” and he discusses various ways in which the market appears to be undervalued. In the opinion piece, the authors note:
From our perspective, the safest bet for investors looking for income and inflation protection may not be bonds. Rather, stocks, particularly stocks paying high dividends, may offer investors a more attractive income and inflation protection than bonds over the coming decade.
We concur with Siegel’s conclusion that stocks are currently attractive and should deliver solid returns over the coming years. One of the keys to successful investing is a willingness to stick with a proven strategy during uncertain times. Today, we think investors should take advantage of low stock valuations and resist the temptation to seek safety in bonds.
