Video Killed the Radio Star — Will Bonds Kill the Bull?

Main content

The market volatility hits just keep coming, notwithstanding good news. Earnings season remains upbeat: as of October 19, FactSet reported that of the 17% of S&P 500 companies reporting 3Q18 results, 80% have beaten EPS expectations and 64% have beaten sales expectations. Nonetheless, even the companies that are nailing estimates and guiding higher are getting the cold shoulder from investors.

China announced more stimulus to prop up its economy but investors are not really buying it. They know monetary stimulus can only go so far and that it will take deep reforms actually to shift the world’s second largest economy into higher gear. In the United States, concerns center around profit margins due to higher input costs from tariffs, a strong U.S. dollar and Federal Reserve rate hikes. Investors have gotten especially jittery ever since they realized Fed Chair Jay Powell is serious about rate hikes (serious as in, “don’t make me turn this car around”). Earlier, they seemed not to believe it, despite lack of a credible inflation threat.

Bond yields jumped higher, and finally are becoming a compelling investment alternative to stocks; but not really, not yet. Even if bond yields move up to 4%, that implies a P/E of 25. The current 10-year U.S. Treasury yield of 3.126% implies a 32 P/E. Stocks are now valued at only a 15.8 P/E, based on their next 12 months of earnings. If you take the inverse of a 15.8 P/E, you get an earnings yield of 6.3%. Therefore, stock valuations are still more compelling than bonds. This is not to say that bonds are not an important part of a portfolio. They offer steady return, diversification and risk control, but they are not stocks.

Please see page 20 of the Global Perspective Book, The Fed Model, for a comparison of stock and bond yields.

Footer content