It is hardly an insight to note that markets today are beset with fears. What is less widely acknowledged and critical to investment strategy, however, is that the level of anxiety has driven market segments to different extremes of valuation. On the one side, widespread fear has driven up the prices of the usual safe havens—U.S. Treasury bonds, gold, the debt of other presumably stronger governments. On the other, it has severely held back relative pricing on equities and credit-sensitive bonds. This divergence presents remarkable investment opportunities. Because valuations have braced so thoroughly for disaster, the least improvement can change the pricing equation radically. The probabilities suggest it will move in the direction of stocks and lesser quality bonds over presumably safer investments.
The concerns that have driven this valuation situation are well known. In addition to the usual Middle Eastern anxieties, there’s an especially acute threat of war in the Persian Gulf. Europe’s sovereign debt crisis continues and threatens to do as much financial and economic harm as America’s 2008-09 subprime crisis. Washington seems unable to find fiscal direction or even begin to address the country’s public debt crisis. And the U.S. economy is growing so slowly that prospects of a second recessionary dip are never far from investors’ minds. This is only a partial list. But in today’s pricing equation, the question is less about the realities of these great risks—something that is indisputable—than whether relative valuations have exaggerated them. The figures on both sides of the safety spectrum suggest that they have.
The safe havens have been so bid up that they offer investors nothing but security. Gold, for instance, has risen by more than 60% over the past couple of years, while the yields on supposedly secure government bonds have fallen to ridiculous lows. Recently German bond yields actually dipped into negative territory, effectively forcing investors to pay Berlin for the privilege of lending it money. Ten-year U.S. Treasury notes, with yields under 2%, still pay a positive nominal return, but with inflation above 2%, investors in these investments still face an ongoing real loss. Deposit rates, held down below 1% by the world’s major central banks, also impose a real loss on those who would seek safety in an insured account. Fear must remain intense just to keep people in the poor-paying assets. The least hint of relief would prompt an exodus.
In contrast, the fear has created very attractive pricing in lesser-quality bonds. There, investor reticence has so held back prices that relative yields can only be described as atypically generous. High-yield bonds, so-called junk, currently yield 750 to 800 basis points above Treasuries. This spread historically averages closer to 500 basis points and, when the economy is in even a modest expansion, it can fall to 300 basis points or less. Things would have to deteriorate considerably to erase such superior payouts. Meanwhile, even if levels of anxiety remain sufficient to maintain the situation, these generous spreads should continue to offer an attraction. And if any relief from these fears emerges, even to a modest degree, these wide yield spreads would protect such bond holders from the capital losses that would almost certainly occur in the safe havens as investors give up on their poor yields.
If anything, equities offer still better value. Even after the market’s recent gains, price-earnings multiples remain well below their long-term averages. Especially compared to today’s low Treasury yields, stocks look cheaper than any time since the early 1950s and, by some metrics, since the Great Depression. The picture painted by dividend yields looks even more compelling. At today’s prices, most popular stock indices atypically offer dividend payouts higher than long-term Treasury yields. At many companies, even those that have paid regular dividends for decades, their stocks currently offer higher yields than their own bonds. Since all a bond will ever pay is its yield, while stocks can appreciate and managements can increase dividends, the relationship between these yields typically is the reverse. That today dividend yields are higher shows how investors, implicitly, have priced into stocks an expectation of either price declines or dividend cuts or both.
Of course, anything could happen. Matters could get worse, forcing markets to price in even greater disasters. Companies, contrary to decades-long patterns, could cut their dividends. Europe could implode. War could break out. But since people’s greatest hopes and worst fears are seldom realized, probabilities would seem to suggest that matters will avoid the catastrophes for which markets have already substantially priced themselves. Even in the absence of unmitigated good news, just a likely muddling through will force markets to adjust their current relative pricing, placing opportunity in the “risk-on” trade, as it is called, that favors stocks and credit-sensitive bonds over the safe havens.
Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo.