What is the Best Value Asset Class: Bonds, Bullion or Stocks?

We start this shortened week on the back foot…

Overnight, the Dow fell another 0.75% after falling around 0.4% on Friday. The S&P 500 fell a hefty 0.81%, oil is down around 3% in two sessions, while bonds and gold rallied.

European markets fell 2%, while London’s FTSE 100 surprisingly outperformed, with a 1.2% decline.

I say surprisingly because the apparent cause of this selloff is fear over Britain leaving the European Union (EU) when it votes in a referendum in about 10 days’ time. The ‘leave’ camp is in the ascendancy, and this is freaking global markets out right now.

No one really knows what Britain outside the EU would look like. And no one knows whether this would be the first domino to fall. A vote to leave could spark other countries to reclaim their sovereignty from the growing monster of European bureaucracy.

If markets begin to price this risk in, we’re in for a prolonged period of volatility. That’s because a long and slow disintegration of the EU means the end of the euro, one of the world’s major currencies.

But that’s jumping the gun a little bit. There are still 10 days for both sides in Britain to fire their propaganda shots and get their desired outcome. Right now a Brexit is looking likely, and overvalued equity markets don’t like it.

But bonds and gold do!

The yield on the US 10-year Treasury note fell to 1.61% overnight. Apart from a one-day drop below this point February, this is the lowest level for 10-year yields since late 2012.

Back then, the S&P 500 was around 35% lower than what it is now…and gold was around 40% higher!

That tells you the bond and equity markets have very differing opinions on the US economy right now. When bond yields are low (meaning prices are high), it tells you that decent economic growth and inflationary pressures are a pipedream.

If that’s the case, companies will find it hard to generate revenue and earnings growth. So that makes the S&P 500, trading on a price to earnings (P/E) ratio of around 24, extremely overvalued.

But in the wacko world of modern finance, with an avalanche of central bank created money searching for a home, we need to put this overvaluation into perspective.

When you buy a 10-year US Treasury bond today, you get an ‘earnings yield’ of 1.61% and the prospect of a capital gain if the yield continues to fall.

When you buy the S&P 500, which is trading on a P/E of 24, you get an earnings yield of 4.16% (1/24). And there is the prospect of capital gains if the economy continues to expand, however modestly.

When you compare these two major asset classes from an ‘earnings yield’ perspective, stocks don’t look too bad. They might seem expensive, given the long term average P/E for the S&P 500 is around 15. But don’t forget, the long term average bond yield is higher too.

I don’t know what it is exactly, but let’s say it’s about 4%. That equates to a P/E of 25 times. In this situation, stocks trading at 15 times earnings seem about right. But with bonds now yielding just 1.61%, the US bond market trades on a P/E ratio of 62!

So what market is more expensive? The stock market on a P/E of 24, or a bond market on a P/E of 62?

By the way, the P/E ratio is a crude measure of an asset’s ‘value’. As a general rule, the lower the number, the cheaper it is. Here’s one way to think of it: Buying the S&P 500 now would take 24 years of current earnings to repay your investment. Buying a 10-year Treasury bond would take quite a bit longer.

But the risk profile of each market is different. You’re pretty much guaranteed payments from US Treasuries. The US government isn’t going to default.

But that guarantee doesn’t extend to the stock market. If the economy slows, company earnings will fall. You won’t get what you thought you would. That’s why stocks are always relatively cheaper than bonds. There is more certainty with bond earnings.

So, getting back to the question, which market is more expensive, and therefore more at risk?

It depends!

If the US and global economy recover strongly from here, the bond market is in real trouble. But if the US economy slows further, or goes into recession, then the stock market is in for a beating.

The risk of Britain leaving the EU plays into this second scenario. I’m not suggesting it will cause a recession. But it will create enough uncertainty to drive capital away from stocks and into bonds and bullion, at least in the short term until everyone works out what a ‘Brexit’ actually means.

It’s also worth pointing out that the last time US Treasury bond yields were lower than where they are now, in late 2012, gold was trading around US$1,800 an ounce. Right now, gold is nearly 30% below that level.

Although we didn’t know it at the time, in 2012 gold was about to enter a nasty bear market. Now, there’s a good chance it’s moving back into a long term bull market.

Perhaps then, out of the three major asset classes of bonds, bullion and equities, bullion is the best value of the lot.


Greg Canavan,
For Markets and Money

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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