10 months ago • 2 mins
A quick and dirty way of comparing the attractiveness of stocks versus bonds (and cash) is to look at their yields. The yield on a bond is an estimate of the return you can expect – under certain assumptions – if you hold the bond to maturity. The yield on stocks (i.e. the earnings yield) represents an estimate of the return you can expect – under certain assumptions – from each dollar invested in the stock. The earnings yield is the inverse of the price-to-earnings (P/E) ratio, so a high earnings yield means that the stock price is cheap in relation to earnings (i.e. the P/E is low).
In normal times, you’d expect stocks to provide a higher yield than corporate bonds, and corporate bonds to provide a higher yield than cash, because of their higher risk. Sure, you’re not exactly comparing apples to apples – and there are assumptions involved – but if you look at them not just relative to each other, but also relative to their own history, you can get useful information regarding the attractiveness of each asset.
And right now, cash seems very attractive in relation to corporate bonds and stocks. As you can see in the chart, you can get pretty much the same yield investing in a virtually risk-free asset like a short-term Treasury bond (4.9%) as you can in corporate bonds (5%) and stocks (5.3%). That’s highly unusual. And historically, it’s been a bad omen for future stock returns, with a shrunken yield gap preceding many of the previous stock market corrections. The reason why is pretty clear: if you can earn as much in risk-free cash as you can on a riskier corporate bond or an even riskier stock, then you might as well shift some of your money away from stocks and corporate bonds – and into cash.
Look at it this way: to invest more of your money in stocks, you’d want a higher expected return through high capital gains. But the thing is, you generally need low starting valuations – i.e. a high earnings yield – to get higher capital gains. That means that until the earnings yield spikes and bond yields fall, your returns on stocks are likely to be limited.
Now, this doesn’t mean you should go all-in on cash. Cash gets eaten by inflation, and unless you invest in long-term bonds, you’re unlikely to lock currently attractive cash rates far into the future. See, yields are likely to fall from here, so when your bond expires, you’d likely only be able to buy it again at a lower yield. But consider keeping at least some cash on the side. You’ll not only get paid an attractive rate for it, but you’ll also be ready to pounce on better investing opportunities when they arise.
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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