Are Stocks Actually Safer than Bonds?

Are stocks safer than bonds right now? I know the idea sounds ludicrous on the face of it. We're in the middle of a nasty correction, and Treasuries have become the world's favorite safe haven, as they were in 2008. But what if the market's reaction is over-reaction-more post-2008-traumatic stress syndrome than a clear-eyed vision of the future?

Stock investors' main worry is the Euro crisis, which raises the likelihood the U.S. will lose a key export market it was counting on to pull out of recession. Since U.S. consumers are still keeping their credit cards in their purses, we're counting on the rest of the world's consumers, for a change, to take over as economic engine. But maybe a cutback by Euro-spenders isn't such a disaster after all. Schwab's Liz Ann Sonders, quoting BCA Research, notes that Europe accounts for only about 14% of the S&P 500's operating earnings. So a 30% decline in the euro against the dollar would shave only 4% off the S&P's earnings. The ever upbeat Jim Paulsen, Chief Investment Strategist at Wells Capital Management, adds that some of the slack is being taken up by surging U.S. exports to emerging markets, which are up 45% from their lows during the crisis.

For the time being, at least, equity analysts seem content that the rally in corporate profits will continue, Euro-mess or no Euro-mess. Blackrock's Bob Doll pointed out in the WSJ op-ed yesterday that for all the fitfulness in the U.S. economic recovery, the rebound in profits is V-shaped, and nominal profits are on track to reach an all-time high by the end of the year. The earnings yield-that is, earnings divided by price, or the inverse of the P/E ratio-is now over 8%, more than twice the yield on 10-year Treasuries, a bullish sign. (That indicator was Alan Greenspan's favorite marker for whether stocks were fairly valued in relation to bonds-but you shouldn't hold that against it.) These are not signs of the end of the world in stocks.

And what about bonds? As Larry Swedroe points out in this CBS MoneyWatch post, the best indicator of their future return is their current yield. On the five-year Treasury, that's 2.1%--a pretty miserly reward when you realize that you can get a 1.8% dividend from a high-quality equity income mutual fund like T. Rowe Price Equity Income. And it's not as if there's no risk: Any positive turn in the economic outlook would cause the bonds to lose their attractiveness as a safe haven, and prices will come down. That, in fact, was what was happening before the whole euro mess started.

Of course, the argument for owning Treasury bonds is that there will be no positive turn in the economic outlook. But even in that environment, the protection may be short-lived, argues Interest Rate Observer's Jim Grant. How will Uncle Sam respond to a double dip? Grant answers: "We suspect it would print more money and, in so doing, stock a new inflation." And you might add, dare the rating agencies to make good on their threat to downgrade Treasuries. Both would be poison for bond prices.

Now, to answer the question that led off this post: Of course, stocks are riskier than bonds, in general. That's why they have a higher expected return. But the relation between them is not fixed, and when the markets are at their most pessimistic, the future can be brighter for stocks. Think back to March 2009, just before stocks started their 70% run through last April.

The best answer to that opening question is Grant's, and I'll leave it here:

Mr. Market delights in shifting labels. When he thinks nobody is looking, he sticks the "risky" label on the "safe" asset and the "safe" label on the "risky" asset. Yet, not infrequently, it's the supposedly risky asset that winds up preserving capital or even delivering capital gains.
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