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Stocks vs. Bonds (2 ways) + How to evaluate this sell off
March 13, 2007, David R. Kotok, Chairman & Chief Investment Officer
How do you decide how much money to put into bonds and how much to allocate to stocks? That is probably Cumberland’s most FAQ (frequently asked question).
We always start with the personalized risk profile of each client and the investment objectives. That is what a personalized money manager (like us) must do. Let’s skip that part for now and go right to the market valuation techniques.
Stocks are valued on their earnings prospects. We look at the trailing earnings and, more importantly, at the future estimates. Part of the price of a stock involves valuing the future growth. Without that growth, stocks would be nothing more than high risk bonds.
After today’s decline, we see the US stock market priced at under 16 times the estimated earnings for 2007. We will use the S&P 500 index for this computation and ignore the companies with losses. This is the most commonly used way to evaluate the market. There are certainly many other methods and we look at all of them but for simplification let’s use this one. We expect the future years’ earnings growth rate to be in the mid-to-high single digits and to increase roughly in line with the growth rate of the US nominal GDP.
The 16 price/earnings multiple (P/E) equates to an earnings yield of about 6.25%. Earnings yield is the reciprocal of P/E. Simply divide 100 by the estimated P/E to get it. Let’s use that as our stock valuation decision point.
We can compare that 6.25% earnings yield to bonds. For today’s exercise we will do it two ways.
Method 1.
If we use the benchmark 10-yr US Treasury note yield of 4.55% as our risk less bond, we can see that the difference between these two numbers is a very substantial 1.70%. In other words, an investor may choose to get a risk less ten year return of 4.55% or may gain an additional 1.70% by foregoing the cash payment on the bond and exchanging it for the dividends and reinvested earnings from the stocks PLUS the next ten year’s growth in those earnings PLUS any appreciation of the stock price. We have to make some assumptions about where the stock market will be priced ten years from now. For this exercise, let’s assume it will follow these ratios without any change.
Method one leads us to what is called the “equity risk premium”. That term describes the traditional measure of how much an investor is paid for taking on stock market risk. With the stock market currently priced to provide an earnings yield of about 138% of the risk less return, we can easily see that stocks appear to be a bargain when computing valuation with the traditional method 1.
Please note that at the top of the market seven years ago, the computed equity risk premium was a negative number. Investors were actually paying for the privilege of owning stocks. Valuations were extraordinary and at extremes. An example: at the peak, Microsoft and Cisco had a combined $1 trillion market cap and were a combined 100 times earnings. In the ensuing sell off the stock market lost $7 trillion in value as the NASDAQ “bubble” collapsed. See: http://www.cumber.com/special/nasdaqpe.pdf .
Method 2.
The thinking here is to use something other than the risk less Treasury bond yield to value stocks. This approach may be argued either way. But many ask: “shouldn’t the comparisons be against bonds which are of similar credit quality as the stocks?” They want to compare “apples with apples.”
Ned Davis Research data helps us here. We will examine the Moody’s BAA corporate bond yield instead of the 10-year Treasury note yield. These BAA bonds are reasonably close to the credit quality of the combined 500 stocks in the S&P Index. This bond yield today is about 5.75%.
Ned has compared the period starting with Paul Volcker’s anti-inflation policy stance in 1980 to present day. This captures 27 years of data during the time when the Federal Reserve was committed to bringing down the inflation rate and removing the inflation distortions from our economy and our business decisions. We agree with this choice of time period. It is consistent with the Bernanke Fed approach being applied today.
Essentially, the spread between the BAA bond yield and the S&P 500 earnings yield is actually negative by about 50 basis points (one-half of 1%). This indicator argues strongly for stocks. It says that the future growth value in stocks is being given away by the market. The investor may exchange the cash flow from the BAA bond interest payment for the stock earnings yield and get all of the growth for nothing. In addition, the investor gets a bonus ½ point in return.
We again examine the NASDAQ “bubble” collapse period and the 1987 stock market crash. In both cases the spread using method 2 was around 4.5%. BAA bonds paid 4.5% MORE in cash than the stocks provided in their earnings yield. You would have to be crazy to own stocks over bonds at those levels. Many crazy people did just that and ended up getting their heads handed to them. Note that at the top of the market in 1987, Cumberland’s clients were about 50% in cash which is about as high as we would ever go.
Today this method 2 is at its lowest strategic level in three decades. A BAA bond yield/S&P 500 earnings yield spread of near zero is a rarity; a negative spread as we have today is an outright gift. That explains why so many companies are buying back their stock or doing leveraged private equity deals.
So why not sell all the bonds and just own stocks is another FAQ? Because history shows that, too, would be a mistake. Risk adjusted returns from portfolios that blend stocks, bonds and cash provide the best long term returns for the risk taken. Putting all the eggs in any basket is a mistake. Today we would favor stocks over bonds. We would allocate something like 55%-60% to stocks and about 5%-10% to cash. The rest should be in bonds with a neutral duration and favoring very high credit quality.
Please note that Professor Jeremy Siegel might disagree with us when taking a strictly market valuation view. We suspect that his forthcoming book will again validate the proposition that, in the very long run, stocks do outperform bonds. He will probably support the earnings approach to valuation.
But also note that we are an individual personalized money manager and that our clients do not all live for 100 years. If they did, and if their time horizon could span a century, and if they could withstand the emotional roller coaster of volatility, then, and only then, would we put everything into stocks.
This exercise today focused on the US stock market and the US bond market. In our daily work we examine the stock markets of most of the world. Only $17 trillion of the world’s $45 trillion market cap is in the US. We also look at all global interest rates and the cross rates among and between the various important currencies.
Today, Cumberland’s strategy is to be fully invested in the stock markets of the world in a much diversified way using exchange-traded funds. Weights of various countries and sectors are determined by proprietary methods. We consider not only yields and earnings, but also political risk and governance characteristics.
Our bond portfolios remain oriented toward the highest quality credits. Our duration targets are near the neutral area when compared with the benchmarks. This is true for both taxable bonds and for tax-free municipal bonds.
The stock market correction is a long awaited phenomenon. No market can go straight up without a pause and some restoration of risk perception. The sell off provides a buying opportunity for those investors who missed that chance last autumn. We would still avoid the housing related sectors and the builders. That problem is now widely known but has more to evolve. The Sub-Prime mortgage issues will also impact the more traditional Alt-A mortgages and even some of the highest grade mortgage areas.
But this mortgage deterioration is not going to become an economy-wide contagion leading to a severe recession. We just don’t see it. The economy is pursuing a slow growth path and inflation pressures remain low. There is continuing job growth and incomes are rising albeit at a slow pace. That is not the recipe for a recession.
David R. Kotok, Chairman & Chief Investment Officer
Stocks vs. Bonds (2 ways) + How to evaluate this sell off
March 13, 2007, David R. Kotok, Chairman & Chief Investment Officer
How do you decide how much money to put into bonds and how much to allocate to stocks? That is probably Cumberland’s most FAQ (frequently asked question).
We always start with the personalized risk profile of each client and the investment objectives. That is what a personalized money manager (like us) must do. Let’s skip that part for now and go right to the market valuation techniques.
Stocks are valued on their earnings prospects. We look at the trailing earnings and, more importantly, at the future estimates. Part of the price of a stock involves valuing the future growth. Without that growth, stocks would be nothing more than high risk bonds.
After today’s decline, we see the US stock market priced at under 16 times the estimated earnings for 2007. We will use the S&P 500 index for this computation and ignore the companies with losses. This is the most commonly used way to evaluate the market. There are certainly many other methods and we look at all of them but for simplification let’s use this one. We expect the future years’ earnings growth rate to be in the mid-to-high single digits and to increase roughly in line with the growth rate of the US nominal GDP.
The 16 price/earnings multiple (P/E) equates to an earnings yield of about 6.25%. Earnings yield is the reciprocal of P/E. Simply divide 100 by the estimated P/E to get it. Let’s use that as our stock valuation decision point.
We can compare that 6.25% earnings yield to bonds. For today’s exercise we will do it two ways.
Method 1.
If we use the benchmark 10-yr US Treasury note yield of 4.55% as our risk less bond, we can see that the difference between these two numbers is a very substantial 1.70%. In other words, an investor may choose to get a risk less ten year return of 4.55% or may gain an additional 1.70% by foregoing the cash payment on the bond and exchanging it for the dividends and reinvested earnings from the stocks PLUS the next ten year’s growth in those earnings PLUS any appreciation of the stock price. We have to make some assumptions about where the stock market will be priced ten years from now. For this exercise, let’s assume it will follow these ratios without any change.
Method one leads us to what is called the “equity risk premium”. That term describes the traditional measure of how much an investor is paid for taking on stock market risk. With the stock market currently priced to provide an earnings yield of about 138% of the risk less return, we can easily see that stocks appear to be a bargain when computing valuation with the traditional method 1.
Please note that at the top of the market seven years ago, the computed equity risk premium was a negative number. Investors were actually paying for the privilege of owning stocks. Valuations were extraordinary and at extremes. An example: at the peak, Microsoft and Cisco had a combined $1 trillion market cap and were a combined 100 times earnings. In the ensuing sell off the stock market lost $7 trillion in value as the NASDAQ “bubble” collapsed. See: http://www.cumber.com/special/nasdaqpe.pdf .
Method 2.
The thinking here is to use something other than the risk less Treasury bond yield to value stocks. This approach may be argued either way. But many ask: “shouldn’t the comparisons be against bonds which are of similar credit quality as the stocks?” They want to compare “apples with apples.”
Ned Davis Research data helps us here. We will examine the Moody’s BAA corporate bond yield instead of the 10-year Treasury note yield. These BAA bonds are reasonably close to the credit quality of the combined 500 stocks in the S&P Index. This bond yield today is about 5.75%.
Ned has compared the period starting with Paul Volcker’s anti-inflation policy stance in 1980 to present day. This captures 27 years of data during the time when the Federal Reserve was committed to bringing down the inflation rate and removing the inflation distortions from our economy and our business decisions. We agree with this choice of time period. It is consistent with the Bernanke Fed approach being applied today.
Essentially, the spread between the BAA bond yield and the S&P 500 earnings yield is actually negative by about 50 basis points (one-half of 1%). This indicator argues strongly for stocks. It says that the future growth value in stocks is being given away by the market. The investor may exchange the cash flow from the BAA bond interest payment for the stock earnings yield and get all of the growth for nothing. In addition, the investor gets a bonus ½ point in return.
We again examine the NASDAQ “bubble” collapse period and the 1987 stock market crash. In both cases the spread using method 2 was around 4.5%. BAA bonds paid 4.5% MORE in cash than the stocks provided in their earnings yield. You would have to be crazy to own stocks over bonds at those levels. Many crazy people did just that and ended up getting their heads handed to them. Note that at the top of the market in 1987, Cumberland’s clients were about 50% in cash which is about as high as we would ever go.
Today this method 2 is at its lowest strategic level in three decades. A BAA bond yield/S&P 500 earnings yield spread of near zero is a rarity; a negative spread as we have today is an outright gift. That explains why so many companies are buying back their stock or doing leveraged private equity deals.
So why not sell all the bonds and just own stocks is another FAQ? Because history shows that, too, would be a mistake. Risk adjusted returns from portfolios that blend stocks, bonds and cash provide the best long term returns for the risk taken. Putting all the eggs in any basket is a mistake. Today we would favor stocks over bonds. We would allocate something like 55%-60% to stocks and about 5%-10% to cash. The rest should be in bonds with a neutral duration and favoring very high credit quality.
Please note that Professor Jeremy Siegel might disagree with us when taking a strictly market valuation view. We suspect that his forthcoming book will again validate the proposition that, in the very long run, stocks do outperform bonds. He will probably support the earnings approach to valuation.
But also note that we are an individual personalized money manager and that our clients do not all live for 100 years. If they did, and if their time horizon could span a century, and if they could withstand the emotional roller coaster of volatility, then, and only then, would we put everything into stocks.
This exercise today focused on the US stock market and the US bond market. In our daily work we examine the stock markets of most of the world. Only $17 trillion of the world’s $45 trillion market cap is in the US. We also look at all global interest rates and the cross rates among and between the various important currencies.
Today, Cumberland’s strategy is to be fully invested in the stock markets of the world in a much diversified way using exchange-traded funds. Weights of various countries and sectors are determined by proprietary methods. We consider not only yields and earnings, but also political risk and governance characteristics.
Our bond portfolios remain oriented toward the highest quality credits. Our duration targets are near the neutral area when compared with the benchmarks. This is true for both taxable bonds and for tax-free municipal bonds.
The stock market correction is a long awaited phenomenon. No market can go straight up without a pause and some restoration of risk perception. The sell off provides a buying opportunity for those investors who missed that chance last autumn. We would still avoid the housing related sectors and the builders. That problem is now widely known but has more to evolve. The Sub-Prime mortgage issues will also impact the more traditional Alt-A mortgages and even some of the highest grade mortgage areas.
But this mortgage deterioration is not going to become an economy-wide contagion leading to a severe recession. We just don’t see it. The economy is pursuing a slow growth path and inflation pressures remain low. There is continuing job growth and incomes are rising albeit at a slow pace. That is not the recipe for a recession.
David R. Kotok, Chairman & Chief Investment Officer
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