4 months ago • 2 mins
If you want to know how attractive stocks are relative to bonds, you can take a look at the difference in their yields. When stocks' valuations soar, their earnings yield – the inverse of their price-to-earnings ratio – plummets. And a low earnings yield can leave you vulnerable if the market stumbles and it limits your profit potential if the market rallies. Think about it like an Alpinist's oxygen supply: when those levels drop, the consequences of any mishaps can be dire.
Historically, a higher initial earnings yield has been a precursor to stellar stock returns. A prime example of this was during the global financial crisis, when the earnings yield was at an extreme high and the investors who took the plunge reaped the rewards.
For bonds, meanwhile, the higher their yield, the more income they deliver. Plus, there's the potential to gain from a decrease in yields (because bond prices rise when yields fall). Now, look at the difference between the earnings yield and the bond yield, and you've got a handy – though rough – guide for the relative appeal of stocks versus bonds. The golden rule: the higher this ratio compared to its history, the more alluring stocks are.
Looking at the current state of affairs, stocks are generally less tempting than bonds, based on this gauge. And they're particularly lackluster in the US, which currently ranks bottom both compared to other regions and its own historical norms. Emerging market and European stocks, meanwhile, are somewhat more enticing, but not by a lot. And then there’s Japan, which appears to be the dark horse, with a positive ratio indicating higher income from stocks. That's why Morgan Stanley strategists are rooting for Japanese stocks over the rest of the world’s.
Bear in mind, this metric isn't all-knowing. But it’s a handy compass in the current market conditions, and a reminder that while US stocks may be in the limelight right now, they're up against stiffer valuation obstacles. So if you're playing the long game, you may want to spread your stock bets around other regions, with Japan and Europe being worthy contenders.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.
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