Updated: Aug 20, 2021
When we're thinking about the market, one thing that is on our minds is the market in a bubble? You turn on your TV and, you often get an oversimplified definition: priced earnings P/Es are high, sell your stocks. This is on people's minds because they see previous valuations in 2000 and 2008. So, it is a fair statement to say valuations are stretched.
Price to Earnings Ratio
The price of the S&P 500 divided by its trailing earnings gives you the price-to-earnings ratio. You can use all sorts of measures for price-earnings, such as trailing or forward. Specifically, we're using a high standard here.
The graph looks at the last 12 months of earnings and shows how much you pay per dollar of earnings. This is how you can value stock, and you don't have to worry about inflation. When earnings increase, the value of stocks should, too. Therefore, a relative valutation of price to earnings is a great way to compare stocks prices over time.
What is the Alternative?
The alternative in the year 2000 and 2008 were bonds. If you would have sold in the 2000 timeframe, the ten-year was paying over 5.5%, and inflation was reasonably low, especially during the recession. However, today we don't have higher yields in the bond market. We're at 1.74%, and inflation expectations are running at 3.3%. Not only is the interest rate low, but inflation is above what that interest rate is paying.
We wanted to put numbers to the story, so here is a more straightforward way of looking at it.
We are showing 33, as the highest P/E- S&P 500, looking at the past 12 months where we know there were some rough patches. The average for stocks is about 2x higher and 3x higher on the average of bonds. Therefore, bonds could be more overvalued than stocks based on historical standards. The only way to improve the P/E ratio on a bond is to have the price decrease. For stocks, the P/E ratios can improve via a drop in stock price, our fear or by earnings moving up, our hope. Earnings moving up is what we expect for stocks currently.
As we enter earnings season, the expectations for earnings are high. We're likely to see "record-breaking" numbers because we're looking back 12 months ago. There were low to no earnings coming in due to the global pandemic.
Just as we compared bonds to stocks using a P/E multiple, we can easily compare stocks to bonds via a normal valuation for bonds by converting both to a yield. The Fed model above compares the earnings yield of stocks to the earnings yield of a bond. Whenever one is over the other, that's the undervalued asset class, and you should invest. If we go back to the sixties, you should have been buying stocks, not bonds, based on the earnings yield. Then, to the eighties, we can see both lines matched up together. As interest rates decreased on bonds, stocks looked more attractive and were also bid up at the same rate. We can see the red line (stocks) is over the blue line (bonds) right now. Once again, not just looking at the P/E, but looking at the earnings yield, we can see stocks are more attractive versus bonds looking at the overall investment opportunity set.
Fixed Income Market Dynamics
The interest rate is the downside risk of bonds. At 1.74% on the 10-year, we're having one of the worst starts over the last 40 years for bonds. Just another 1%, and we would see further decreases of 7-9% in the ten-year treasury. So there's undoubtedly some downside risk in bonds.
Government spending can cause interest rates to increase because there's only so much money that can be invested. The way that the U.S. has been offsetting a significant steep increase is by printing money, but that can cause inflation expectations, which can also cause interest rates to move up.
Ultimately, I think the risk for fixed-income is the long-term risk of inflation. Especially at low-interest rates, because if interest rates increase and you see the drop in your treasury, over time, it's just going to appreciate at the higher interest rate and give you back all the cash you expect.
There's never going to be any more upside to the bond from when you bought it. So if we had a $1000 bond and it pays us 1% while holding it for 20 years, you will get about $1,200 at the end. $1,200 is more than $1000, but what about that purchasing price in $1,200?
In the cost of basket goods, assume the basket today costs $100. We're going to inflate it by 2%, 4%, and 6%.
The bond appreciated 20% at a 2% inflation, so the $100 basket of goods cost you $150. Now at 4%, it's more than double at over $200 in 20 years. It is unusual to see 6% inflation over 20 years, but if you did, it would be over $300. Another way to think about this is to compare the bonds to the cost of goods. In other words, what is the effect of my purchasing power on that basket of goods, assuming that I've invested and I'm earning 1% and I'm losing 2%, 4%, or 6%.
In the 2%, you're losing 1% to inflation each year. At 4%, you're losing 3%, which has historically been the expected norm for inflation. Then, at 6%, you're losing over half to inflation each year.
The income that you're going to get on the bonds will be taxed. Typically you buy bonds where there is some cost or investment management fees. It's not beyond the realm of possibility to be somewhere between 3-5%, especially since 3% has been the historical norm on the loss of purchasing power. We have a mission to help clients become financially self-reliant, and bonds will not fill that role. Gatewood Wealth Solutions doesn't see bonds playing a role in preserving purchasing power and wealth at the current low interst rates.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
All indices are unmanaged and may not be invested directly. The economic forecasts outlined in this material may not develop as predicted, and there can be no guarantee that the strategies promoted will be successful.
All investing involves risk, including the possible loss of principal. No strategy assures success or protects against loss.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price.