Stocks Are Cheap, Bonds Are Not

09/07/2010 12:00 pm EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, managing editor of Investment Quality Trends, says investors are going overboard for bonds when quality stocks are paying excellent dividends.

In typical summer fashion, the trading volume in equities has been somewhat less than paltry. When there’s no one to trade, a lot of trading doesn’t get done. There’s a reason we call these times “the dog days of summer.”

In the bond market, however, trading and enthusiasm for all things with a coupon attached has been downright giddy. IBM (NYSE: IBM) just sold a three-year note with a 1% yield. Johnson & Johnson (NYSE: JNJ) was able to sell all they wanted of a ten-year offering that pays 3.1%.

In the case of IBM, its stock has a dividend yield of around 2.1%; JNJ’s stock yields around 3.7%. Are investors’ expectations for stock returns so depressed that they think these companies’ debt offerings are a far better choice for investment capital than the stocks?

Apparently so.

With the recent huge rally in the Treasury market, the yield on the ten-year is now around 2.7%. After a 28-year bull market, though, one really has to ask, just how much higher can bond prices rise?

The only reasonable explanation for taking these kinds of risks is the belief that another recession is coming and bonds are the best place to hide. If you don’t think you can lose money in the bond market, well, learning is experiential.

I think the stocks of great companies like IBM and JNJ will outperform their recently issued debt for the next three and ten years. This isn’t to say that the stock market can’t decline further; Heaven knows there is enough bearish sentiment to support that outcome.

[But] too many folks are looking for the big decline right now. A bullish trend in the stock market typically ends after investors have moved large amounts of money from cash and bonds into stocks. According to the Investment Company Institute, in the past three years, investors have moved unprecedented amounts of money from stocks to bonds.

In keeping with the theory that Mr. Market will do the exact opposite of what the majority expects, going back to 1977, there have been 14 bond-market rallies of 10% or more that lasted at least four months. In 75% of the cases, the Standard & Poor’s 500 rose in the following one, three, six, and twelve months.

While I’m not making any prognostications, the bond side of the equation has gotten a little overcrowded and the boat is starting to list. I would expect to see some equilibrium here before too long.

In closing, there is no free lunch. If you put your investment capital to work in the financial markets you are exposing that capital to risk. That is the way it should be if you hope to earn a return on investment.

Great companies purchased at historically repetitive areas of low-price/high-yield can and will go down in a broad sell-off. History shows that they go down less, however, and are generally the first to recover. Ultimately, where value exists, the market will find it.

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