A Case for Stocks from Bond Valuations

U.S. stocks have powered back to record highs, and they could benefit more from a relatively expensive fixed income market.

As shown in the LPL Chart of the Day, Stocks Appear Historically Cheap Relative to Bonds, S&P 500 Index stocks are at their most attractive valuations relative to Treasuries in nearly three years. This data is based on a metric we track called the equity risk premium (ERP), which compares the earnings yield on equities (or company profitability as a percent of share price) to the 10-year Treasury yield.

 

There are several different ways to view stock and bond valuations, so the ERP is only one piece of the puzzle. However, the ERP’s recent ascent shows how much global buying pressure has crimped U.S. yields this year.

“The latest monetary policy U-turn, trade uncertainty, and stubbornly low inflation have boosted Treasury prices, leaving the 10-year Treasury yielding about 2%,” said LPL Research Chief Investment Strategist John Lynch. “We believe the current level of yields makes valuations for Treasuries rather expensive, and they could remain expensive if these catalysts persist.”

If bond investors aren’t getting an adequate payout on Treasuries (relative to price), they’re more likely to search for an alternative. That alternative could be U.S. stocks, especially those that pay dividends. S&P 500 stocks are also relatively attractive on their own. The index’s price-to-earnings ratio (P/E) based on earnings over the last 12 months is around 18— slightly above average for this bull market, but meaningfully lower than where valuations stood during 2017 and 2018.

In regards to fixed income allocations, we continue to favor a balance of high-quality intermediate bonds, with a preference for investment-grade corporate bonds and mortgage-backed securities over Treasuries, as we mentioned in our Midyear Outlook 2019. Bonds can still play a vital role in suitable investors’ portfolios as they could provide a hedge to stock market volatility, in addition to interest income and liquidity.

For more of our thoughts on where equities could go from here, check out our latest Weekly Market Commentary: Riding the Wave…For Now.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.

All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. All performance referenced is historical and is no guarantee of future results.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.

Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio.

This Research material was prepared by LPL Financial, LLC.

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