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In these dog days of summer, we are witnessing the continuation of a multi-year trend. Investors and their advisors are pouring dollar after dollar into fixed income funds while largely fleeing equities.
This year, stock funds have endured a net $1.1 billion in outflows while bond funds have enjoyed $177.6 billion in inflows, according to the Investment Company Institute. This is a carry-over of a theme from 2009, when investors dumped over $284 billion into taxable bond funds and over $72 billion into municipal bond funds while yanking almost $26 billion from equity funds.
As evidence of this bond boom, Pacific Investment Management Company, or PIMCO, the world’s largest manager of fixed income funds, has recently been attracting an astonishing $1 billion a week from investors, according to Bill Gross, the firm’s co-founder and co-chief investment officer.
The average investor is clearly voting with his feet. But given the spotty track record of retail investors, this persistent trend makes us question whether stocks or bonds offer greater value in today’s environment.
American corporations are responding to robust investor demand for fixed income by issuing new debt at very low interest rates. According to The Wall Street Journal, “this month has been the busiest July on record for sales by U.S. companies with junk-credit ratings. Asia’s debt market is on pace for a record year, and European companies are also raising money apace.”
Last week, McDonald’s issued $450 million in 10-year debt at 3.5%, a record low yield for a large U.S. corporate issuance. And as one would expect, current yields on U.S. government debt are even lower, with the 10-year Treasury bill generating less than 3% and even the longer 30-year Treasury bond yielding about 4%.
In other words, interest rates are extremely low and unlikely to fall much further. While Federal Reserve Chairman Ben Bernanke recently reiterated his commitment to keeping the central bank’s benchmark overnight rate around zero for an “extended period,” continued stabilization in the U.S. economy over the coming months and years should eventually drive interest rates higher.
And as we have articulated in past market updates, there exists an inverse relationship between interest rates and bond prices. If and when rates rise, bond prices will surely fall. Even PIMCO’s Gross, often branded “the Bond King,” estimates that “bonds have seen their best days.”
We know that bonds, in general, offer investors perceived safety of principal, but in exchange for wretched current yields. Throw in exposure to rising interest rates, and bonds appear to be a mediocre investment at best and a dangerous mirage at worst. On the other hand, stocks appear to offer a solid value by several measures.
Based on price-to-earnings (P/E) multiples, equities appear inexpensive. Thirteen of the 25 largest companies in the Standard & Poor’s 500 now trade at or below 10 times estimated 2011 profits, including ExxonMobil, Microsoft, Intel, Merck, IBM and Hewlett-Packard.
The average P/E ratio among the entire S&P 500 stands at roughly 15 and U.S. companies are continuing to grow earnings at a rapid pace. About 80% of S&P 500 companies have released their second-quarter earnings so far, and 78% of them have beaten analysts’ estimates, according to Thomson Reuters. On average, earnings per share are up 37% year-over-year, compared with the 27% growth analysts expected.
A stock’s earnings yield, or the inverse of its P/E ratio, is often compared to bond yields to gauge the relative value of each. In a July 3rd Barron’s article, Oppenheimer strategist Brian Belski noted that the present 8% earnings yield on the S&P 500 is five percentage points above the 3% yield on the 10-year Treasury note. Belski’s research shows that, historically, when the gap has been this wide, the average one-year return on the S&P has been 26.7%.
Although we believe stocks offer substantially more value than bonds, fixed income should still play a vital role in many portfolios, even considering the high probability of a rising interest rate environment in the future. From 1941 to 1981, a period of escalating rates, government bonds generated a total annual return of 3.3%, according to Fidelity Management & Research Co. But when used to complement equities, “a 20% allocation to bonds shaved off more than one-fifth of the portfolio’s volatility, yet only marginally lowered the overall return (from 11% to just below 10%).”
All bond investment strategies, though, are not created equal. When you invest in a bond mutual fund the decisions of other fund shareholders greatly affect you. For investors who need stability and a steady stream of income within a portfolio, we believe in the time-tested strategy of laddering a portfolio of high-quality individual bonds rather than investing in bond funds.
When constructing portfolios to match client risk and reward parameters, we arrive at an appropriate long-term asset allocation between equities and fixed income. Presently, when implementing these long-term allocations, we recommend a tactical slant favoring stocks over bonds.
When faced with overwhelming investor favoritism toward a certain asset class, it is advisable to follow the words of poet Robert Frost: “Two roads diverged in a wood, and I – / I took the one less traveled by, / And that has made all the difference.”
Our investment approach is straightforward, transparent and independent. We invite you to work with us.