The classic choice most investors make when determining where to put their money is how much to put in bonds – typically U.S. Treasuries – and how much to put in stocks. While investor fear levels can have an impact on where they put their money, the ability to make a good risk-adjusted return (RAR) on their investment also plays a major role. If it looks like they can make a better RAR in Treasuries, investors will move their money there. If it looks like they can make a better RAR in stocks, investors will move their money there.
Currently, the yield you can make in Treasuries is woefully low. It has been hovering in the 1.5% to 1.7% range since summer.
With yields that low in the Treasury market, you would expect investors to be stampeding to the stock market in search of higher returns. However, this hasn’t happened.
Rate of Return: Stocks vs. Treasuries
When we say stocks are “cheap,” we are making our comparison to U.S. Treasuries, but we compare apples to apples. When we talk about Treasuries, we talk in terms of yield, but when we talk about stocks, we talk in terms of P/E. To get a better comparison, we need to invert P/E. This will give us an expected rate of return (ROR), which aligns much better when making a comparison with Treasury yields.
To invert P/E, we simply divide 1 by the P/E. For example, the current P/E for the S&P 500 (as illustrated in Figure 1) is 15.52. To invert this, we would use the following equation:
1 ÷ 15.52 = 0.0644 = 6.4%
Click to EnlargeSo the current expected ROR for the S&P 500 is 6.4%. That is much higher than the current yield on the 10-year Treasury of 1.66%. However, we can’t forget the role dividends play in the expected returns for the S&P 500. For the sake of example, the current dividend yield for the S&P 500 was 2.13% this Wednesday.
To get the complete picture of what stock investors expect to receive from their investments, we need to combine the ROR (i.e. the inverted P/E) and the dividend yield for the S&P 500 as follows:
6.4% + 2.13% = 8.53%
That’s a pretty high return compared to the paltry yields 10-year Treasuries are offering. The reason it is so high is that stock investors are demanding a risk premium on their investments. They are nervous about the future, and they want to be compensated for the extra risk they are taking on by buying stocks.
The Effect of Uncertainty
Historically, the spread between the expected return in the stock market and the expected yield in the Treasury market isn’t this wide. Only during times of extreme uncertainty does the spread widen out like this. To calculate the spread you use the following equation:
Click to Enlarge S&P 500 ROR + S&P 500 Dividend Yield – 10-Year Treasury Yield = Spread
In our current market situation, the spread looks like this:
6.4% + 2.13% – 1.66% = 6.87% spread
To put the current spread in perspective, the spread hadn’t risen much above 3% during the 30 years before the financial crisis.
If stock investors were more confident about the future, they would be pushing stock prices higher and higher, which in turn would be pushing the ROR lower and lower, until the spread between expected stock market returned and 10-year Treasury yields moved back to historically “normal” levels.
Bottom Line: Stocks are Cheap
Stocks are cheap and likely to remain so while we wait to see if we are going to go over the fiscal cliff and if Europe is going to be able to keep their currency union from unraveling. However, we need to keep things in perspective. If we see rays of hope coming out of Washington D.C., stocks have a lot of room to move higher. So even though we are in a bearish pullback, we need to realize there is a lot of bullish kinetic energy building in the market that could take off if it were given the chance.
John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.