Prepared by

The Northern Trust Company

Everyone knows that, in the long run, stocks will earn you a higher return than will cash or bonds. And all of us are, of course, long-run investors. The folks who bought Japanese stocks in late 1989 when the Nikkei 225 index stood at 39,000 or thereabouts were, no doubt, long-run investors. They know that Nikkei, which currently stands in the neighborhood of 17,000, will get above 39,000–someday.

It used to be said that bonds were investments suitable mostly for widows and orphans. Bonds used to be considered a less risky asset class than stocks. That doesn't seem to be the case anymore. Ponder for a moment Chart 1. From 1948:Q1 through 1967:Q2, the earnings yield on stocks consistently lay above the nominal yield on AAA corporate bonds. But roles have reversed. Starting in 1980:Q4, the nominal yield on high quality bonds consistently has been above the earnings yield on stocks. What brought about this reversal in yield relationships? The passage of time and the ratcheting up of inflation in the late 1960's through the early 1980's. A lot of current stock market investors may not know this, but there was a severe deflation in equity values in the U.S., starting in October of 1929. The major US stock market indexes did not return to their pre-crash 1929 highs until the early 1950's. These lean years of stock market returns were still fresh in the memories of many who were investing in the 1950's and 1960's. Because of the experience of the 1930's, stocks were perceived to be risky assets. High quality bonds, on the other hand, weathered the 1930's much better than did stocks. Although inflation may be the enemy of bonds, deflation is a high quality bond's best friend. And, of course, it was deflation that we experienced in the 1930's. In the postwar period up to the mid- 1960's, there were short bouts of inflation. But that's just it–they were short. And they largely were associated with wars–a surge in inflation soon after W.W.II when price controls were lifted and a surge in inflation during the Korean conflict. But by and large, from the mid-1950's through the mid- 1960's, inflation was quiescent. In this low inflation environment, bonds were perceived to be a very low-risk investment relative to stocks. But starting in the second half of the 1960's and running through the early 1980's, inflation ratcheted up. Suddenly, bonds were not such a low risk investment anymore. So, while the Great Depression of the 1930's permanently scarred the psyche of the bulk of investors of the 1950's to 1960's, the Great Inflation of the 1970's is fresh in the memories of many of the investors of the 1980's and 1990's. On the basis of the 1930's, investors of the 1950's and 1960's “learned” that stock market crashes were not buying opportunities. In contrast, investors of the 1990s “learned” that market crashes were buying opportunities on the basis of the 1987 experience. Perhaps investors of the 1980's and 1990's have come to expect that economic policymakers will accept higher inflation in order to avoid a depression. How bad could it get for stocks relative to bonds if there isn't going to be a depression again? This, in my opinion is why, starting in the early 1980's, the earnings yield on stocks has consistently been below the nominal yield on high quality bonds.

*–Yr./y. pct. chg. in CPI.

**–Earnings yld. on S&P (based on 4 qtr. trailing earnings.

***–Yld. on seasonal AAA corporate bond.

Although I would assess the risks as being higher that we would experience a pick up in inflation in the foreseeable future than the risks that we will experience a depression, I can't help but wonder if fixed-income instruments–cash and bonds–are not now the Rodney Dangerfields of financial assets. They don't seem to get much “respect” from investors. In the third quarter of this year, stocks appeared to be “expensive” relative to cash and bonds. On what basis might we compare stocks to cash or bonds? I believe that the yield on stocks–the inverse of the price-to-earnings ratio–is a real yield. It seems reasonable to me to assume that aggregate nominal corporate earnings over time ought to increase at least apace with inflation. It also seems reasonable to me to assume that the nominal value of aggregate corporate assets over time ought to increase at least as fast as the inflation rate. The yield on stocks is corporate earnings divided by the capitalized value of corporate assets, or the value of stocks. Because both the numerator and denominator involved in the calculation of the yield on stocks are assumed to rise at least as fast as the inflation rate, this yield on stocks is a real yield. Because the yield on stocks is a real yield, then for comparative purposes, we need to look at the real yield on cash or bonds. And that's what I have done in Charts 2 and 3.

*–Earnings yield on S&P 500 (based on 4-qtr. trailing earnings).

**–Nominal Fed funds rate less yr./yr. pct. chg. in CPI.

*–Earnings yield on S&P 500 (based on 4-qtr. trailing earnings).

**–Yld. on sesasoned AAA corporate bond less yr./yr. pct. chg. in CPI.

Plotted in Chart 2 is the earnings yield on the S&P 500, the “real” fed funds rate and the basis-point difference between the two (earnings yield less real fed funds rate). In this past third quarter, the earnings yield exceeded the real fed funds rate by 89 basis points. In the 68 quarters starting in 1980:Q4, the median difference between these two yields is 365 basis points. The minimum difference was 54 basis points, set in 1986:Q2. The period from 1960 through 1965 was one of low inflation. Using quarterly data, the year-over-year percent change in the CPI averaged 1.3% during the first half of the 1960's. How does the difference between the earnings yield on stocks and the real fed funds rate for the 1960-1965 low inflation period stack up against the current difference in today's low inflation environment? In the first half of the 1960s, the median difference was 354 basis points–substantially higher than this past quarter's 89 basis points. So, in an historical context, currently, the real yield on cash is very attractive relative to the yield on stocks.

Plotted in Chart 3 is the earnings yield on the S&P 500, the “real” yield on AAA seasoned corporate bonds and the basis-point difference between the two (earnings yield less real bond yield). In this past third quarter, the stock earnings yield was 75 basis points below the real bond yield. In the period starting 1980:Q4, the median difference between these two yields is a positive 90 basis points. The minimum difference is minus 172 basis points, set back in 1983:Q3. In the 1960-1965 period low inflation period, the median spread of the earnings yield on stocks over the real corporate bond yield was a positive 245 basis points versus the past quarter's negative 75 basis points. Again, in an historical context, currently, the real yield on bonds is very attractive relative to the yield on stocks.

The fact that stocks are “expensive” relative to cash and bonds does not necessarily imply that stock prices are going to sink. The relative value of stocks could increase with stock prices staying at their current levels, but with real cash and bond yields falling. But suppose over the next six months the Fed raises the nominal funds rate 25 basis points to 50 basis points and suppose that inflation does not rise as much. Under these circumstances, the real fed funds rate would move up. Then cash would be an even more attractive asset relative to stocks, assuming no increase in the earnings yield on stocks. A rise in the fed funds rate might also be accompanied by a rise in bond yields. Several months down the road, this would make bonds also even more attractive to stocks, all else the same.

In sum, given current relative yields, a risk- reward calculus would favor cash and bonds over stocks. This is not to suggest that investors should sell all of their stocks and go into cash and/or bonds. But what it does suggest is that investors who have seen the stock weighting of their portfolios increase because of the runup in stock prices in the past 2½ years might want to “re-balance” into the Rodney Dangerfield of financial assets–fixed-income instruments.

October 24, 1997Paul L. Kasriel

The Northern Trust Company

50 South LaSalle Street, Chicago, Illinois

Financial Commentary

THE ALLENDALE ADVISORY REPORT | STRATEGY FOCUS | WEEKLY OUTLOOK
ECONOMIC PERSPECTIVE | FED STEER PRICES GOING NOWHERE FAST
U.S. ECONOMIC AND INTEREST-RATE OUTLOOK
STICKING WITH THE U.S. TREASURY MARKET | THE TODD MARKET TIMER
CASH AND BONDS-- THE RODNEY DANGERFIELDS OF FINANCIAL ASSETS?
MYERS ON FUTURES | THE COPPER JOURNAL | COMMODITY FUTURES FORECAST WEEKLY REPORT
INTEREST RATE WATCH | NIKKO MARKET COMMENTS

Consensus National Futures and Financial On Line Index

Copyright 1997, by Consensus Inc.  All American and Pan American rights Reserved. editor@consensus-inc.com

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