With Yields This Good, Stocks Suddenly Aren’t So Special

With Yields This Good, Stocks Suddenly Aren’t So Special
Reda Farran, CFA

8 months ago2 mins

Mentioned in story

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 P/E is low and the stock price is cheap in relation to earnings. The yield on cash is the return you can expect on risk-free, ultra-short-term, highly liquid government bonds, such as three-month US Treasury bills.

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. But today, the steep surge in interest rates, coupled with the recent impressive performance of the stock market, has meant that the yields on cash, bonds, and stocks are the same in the US for the first time ever.

Cash in the form of three-month US Treasury bills is currently yielding 5.2%, after the Federal Reserve held interest rates at between 5% and 5.25% but hinted at two additional quarter-point increases this year. That’s roughly the same level as the 5.1% expected 12-month forward earnings yield on the S&P 500 and the 5.2% yield on investment-grade corporate bonds.

So cash is looking very attractive compared to corporate bonds and stocks. After all, 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.

Now, this doesn’t mean you should go all-in on cash. Cash gets eaten by inflation, and because you’re investing in ultra-short-term government bonds, you’re unlikely to lock currently attractive cash rates far into the future. See, yields aren’t likely to rise much from here and eventually will fall, 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.



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