The Federal Reserve’s FOMC has now cut interest rates twice in the last sixty days and the Fed Funds target rate is 4.50% to 4.75%. This is supposed to be good news for the bond market to bring down interest rates. This, in turn, is also supposed to make stocks cheaper on a relative basis to bonds. The only problem is that long-term Treasury rates actually went up handily. This could pose new competition and concerns for an increasingly expensive stock market at all-time highs.
Oggonomics wants to know if the current premium you pay for stocks over the safety of bonds is worth it. Let’s just say — it’s complicated!
The yield on the 10-year Treasury went down to about 3.63% in September, right around the Fed’s first rate cut. This last week it hit 4.43% before settling back down at 4.31%. So maybe it’s not as bad as it was, but this is still a case of longer-term note and bond yields going the wrong way. Fears of the ever-growing government deficit ($36 trillion or so) and the potentiality of tariffs rekindling a tamer inflation environment could bring at least some concerns ahead.
STOCKS AT ALL-TIME HIGHS
Now for the real kicker with the Dow, S&P 500 and NASDAQ all basically at all-time highs after surging on the election results. The S&P 500 is currently close to 23 times expected earnings. The historical average is closer to 20-times.
Using an inverse mathematical calculation to drive an earnings yield is an old trick to see if stocks are expensive or cheap against the 10-year Treasury — at 23-times and at 20-times earnings, the respective full earnings yield is 4.34% at 23-times and 5.00% at 20-times.
FLIPPING THE MATH ON TREASURIES
Now try turning the 10-year Treasury yield into an inverse to come up with its relative price-to-earnings ratio. Dividing 1 by the 4.31% Treasury yield generates a 23.2 P/E equivalent.
Now consider Friday’s closing bell dilemma after a Dow Jones headline confirmed that the S&P 500 set its 50th record closing price and that the index closed up 4.95% in just the last four trading session. A 4.50% yield using the same inversion calculation is 22.2 and a 5% yield makes the Treasury’s ratio 20.
ALSO READ: 20 NATIONS THAT OWN THE MOST TREASURY DEBT
WHAT ABOUT RISK-FREE?
Using the yields of Treasury securities do matter because this is supposed to be the risk-free rate of return. You just have to buy it and hold it and when it matures in ten years you have been paid interest (like dividends) and get your money back — hence risk-free!
It may not seem like there is risk in stocks because the market’s propensity has been to rise. But at the current handle close to 23 on an earnings yield and an inverted yield ratio of 23.2 for longer Treasuries it starts to sound like the market is fully valued.
Just keep in mind that corporate earnings tend to rise over time, so that picture can look far better for stocks and static for bonds zooming forward three to five years in the future.
TREASURIES vs. DIVIDENDS
Let’s pretend for a moment that longer-dated Treasury yields were back down to that 3.63% level. Or what about at 3% yields from mid-2022? Those inverse earnings yield ratios go up to 27.5 or 33.3, respectively. And a 2% yield on the 10-year, where it was before the rate-hike campaign began would make for a ratio of 50. Suddenly stocks look or sound very cheap — but the S&P ratio never gets that out of whack against reality.
Here are some other yield comparisons to consider against Treasury yields:
- The current yield of the S&P 500, at least using the SPDR S&P 500 ETF (NYSEArca: SPY) is just 1.23%. There are 92 members of the S&P 500 which pay no dividend at all.
- The ProShares S&P 500 Dividend Aristocrats ETF (NYSEArca: NOBL), which tracks companies with 25 straight years of dividend hikes has a 2.04% yield.
- The Financial Select Sector SPDR Fund (NYSEArca: XLF), which mostly tracks financial stocks (and Berkshire Hathaway, with no dividend), has a 1.43% yield.
- The Financial Select Sector SPDR Fund (NYSEArca: XLF) is considered the closest to Treasuries in stocks because utilities have considerable long-term borrowing needs. Its yield is 2.77%.
ALSO READ: 12 MAJOR POST-ELECTION WINNERS FOR Strategic investors
And for a bond comparison… The Vanguard Total Bond Market Index Fund (NASDAQ: BND) tracks a wide array of taxable investment-grade bond maturities of greater than 1-year and includes government, corporate, international (in dollars), mortgage and asset-backed securities. Its current yield is 3.52%.
RELATIVELY SPEAKING…
It’s hard parsing out relative numbers when determining if stocks are bonds are actually expensive or whether they only appear that way based on current valuations. The Treasury comparisons are always static, but the earnings power of corporations over time implies that the forward P/E ratio say three to five years into the future is what saves the day.
Now we just have to see if earnings really grow enough in the next three to five years to make stocks justifiable. We won’t know until we are much closer to that time — and hopefully Treasury yields will be down handily by that time. And hopefully the sudden less aggressive rate cut outlook will not be as muted. Hopefully.
DISCLAIMER
None of the figures and estimates herein should be considered investment advice or a recommendation to buy or sell any of the securities mentioned. These figures and representations also do not constitute market forecasts. Any decisions to buy or sell stocks and bonds are up to each investor individually and those decisions should be made with a financial advisor. Investing comes with risk and may result in financial losses.
