Balloons and bonds
Rocky observes that when he pinches a balloon on one end, it expands on the other end. This simple revelation has implications for his friends who continue to buy corporate bonds at ever lower yields, while ignoring the effects that it has on the stock prices of the same companies.
Bill Miller writes in his latest commentary, “US large capitalization stocks represent a once in a lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951. I was 1 year old then, but did not have then sufficient sentience or capital to invest.”
Rocky doesn’t remember 1951, so he ran some tests on Dow Jones Industrial Average stocks and bonds to test Mr. Miller’s hypothesis, and found that the conclusions are impressive — even if one makes the improbable assumption that there is ZERO real earnings growth over the next ten years.
(During the 2008/2009 financial crisis, corporate bonds were getting hammered too, so one could not have done this analysis in 2008. Also, so long as the US population continues to grow, it’s extremely difficult to have zero economic growth, so this is a very conservative assumption.)
Rocky’s choice : (1) Buy an equal-weighted basket of the 10-year debt of “quality” companies or (2) Buy an equal-weighted basket of the stocks of the same companies. Buy and hold for ten years.
Analysis of choice #1 (bonds):
The average return is 3.9%. This is the best case and assumes no defaults, leveraged buyouts, or other credit events.
Analysis of choice #2 (stocks):
The current average dividend yield is 2.9% per year on the stocks.
The current average earnings yield is 6.3%.
So if one owns this stock basket and there is no earnings growth and no dividend growth, and the economy is Japanese-like, with intermittent recessions and growth, the return is 2.9% + 6.3% = 9.2% per year for the next ten years. (Which is remarkably close to the long-term average return for stocks.) Here Rocky assumes no bankruptcies and assumes a terminal p/e which is unchanged. But it also ignores the possibility that the economy could do much much better (or much worse).
Some might quarrel that Rocky is double counting … when he includes the dividends. So he says, “ok, let’s forget about the dividends.” Then, the stock basket’s earnings yield is 6.3% and the bond basket yield is still 3.9%, so it’s a pickup of 240 basis points per year for the risk/reward of owning stocks. Or, put another way, over a 10 year period, 10 x 2.4 = 24% … which means that the earnings yield could decline by more than 20% over the next decade and Rocky would still be better off in the stock market than in the bonds of the same companies.
None of this is making Rocky rush out to buy oodles of stocks tomorrow morning — because it’s certainly possible that stocks AND bonds may decline over the next ten years. However, for an investor in corporate bonds, this is an important result — particularly since in a SEVERE deflation or economic crisis, corporate bonds can get hurt badly. Note that Rocky did not include government bonds in this analysis — only corporate bonds.
Lastly, if stocks keep declining and corporate bonds keep rising, the relative values will become more attractive, however, at some point, corporations will issue new debt and use their cash to repurchase shares … and that’s what will keep the relationship between corporate bonds and stocks in line. Perhaps not at these relative valuations … but at some point.
Column1 = stock ticker
Column2 = dividend yield
Column3 = earnings yield. That is, earnings/price for the trailing 12 months.
Column4 = that company’s yield-to-maturity on its 10year corp bullet bond.
Column5 = earnings yield minus bond yield.
[There is a bit of fudging because Intel has no debt, so Rocky arbitrarily gave it a 3.2%. And he extrapolated some companies who had debt maturing in 8 years or 12 years.]
Data source: Bloomberg
|Dividend||Earnings||10 Yr Corp||Earnings YLD|
|Yield||Yield||Yield||minus 10 Yr Bond Yld|
|AA UN Equity||1.1||-5.6||5.7||-11.3|
|AXP UN Equity||1.7||3.7||4.5||-0.9|
|BA UN Equity||2.7||3.5||3.3||0.2|
|BAC UN Equity||0.3||2.5||5.8||-3.3|
|CAT UN Equity||2.6||3.8||3.9||-0.1|
|CSCO UW Equity||0.0||5.6||3.6||2.0|
|CVX UN Equity||4.0||7.4||4.5||2.9|
|DD UN Equity||4.5||6.0||3.6||2.4|
|DIS UN Equity||1.1||6.7||3.2||3.5|
|GE UN Equity||2.7||8.2||4.9||3.3|
|HD UN Equity||3.4||5.9||3.2||2.7|
|HPQ UN Equity||0.7||8.1||3.2||4.9|
|IBM UN Equity||2.1||7.6||4.0||3.7|
|INTC UW Equity||3.0||6.0||3.2||2.8|
|JNJ UN Equity||3.8||7.2||3.7||3.5|
|JPM UN Equity||0.5||6.5||5.1||1.4|
|KFT UN Equity||4.0||7.5||4.3||3.2|
|KO UN Equity||3.3||5.4||3.3||2.1|
|MCD UN Equity||3.1||6.4||4.2||2.2|
|MMM UN Equity||2.6||5.7||3.2||2.4|
|MRK UN Equity||4.3||8.8||3.4||5.4|
|MSFT UW Equity||2.1||7.3||3.0||4.3|
|PFE UN Equity||5.0||11.1||3.1||8.0|
|PG UN Equity||3.2||7.2||3.4||3.8|
|T UN Equity||6.7||7.6||4.5||3.1|
|TRV UN Equity||2.9||12.6||4.2||8.4|
|UTX UN Equity||2.5||6.6||3.5||3.1|
|VZ UN Equity||7.2||7.2||4.8||2.4|
|WMT UN Equity||2.4||6.9||3.7||3.2|
|XOM UN Equity||3.0||5.9||4.1||1.8|
|Equal Wgt Avg||2.9||6.3||3.9||2.4|
[Disclosure: Rocky is not recommending that anyone do anything that involves money or bonds or stocks or shoelaces. But he’s watching this relationship and has started to gradually move some of his “high quality” corporate bonds into the stocks of the same companies — as the relationship becomes ever more attractive. He also notes that if you pinch a balloon TOO hard, it will burst. ]