Stock and Bond Valuations (09/06/2016)

At times, investment markets can project too far into the future, with undetermined consequences. We are in that type of situation now. Bond interest rates have been pushed to all time lows as central banks across the world attempt to create stimulus to get their economies moving. They have, in some cases, pushed interest rates into negative territory.

Many investors, therefore, have been motivated to move more of their money out of bonds and into dividend-paying stocks. With bond interest rates so low and the desire to get higher income, the move is understandable. The difficulty is that these somewhat higher yields come with a price. The price is called volatility. Volatility represents the level of change, up or down, in the value of an investment.

To determine volatility, market watchers use a mathematical formula called “standard deviation.” This formula measures the change, up or down, in the price of an investment from its normal average. A lower standard deviation generally means less risk. For example, according to Barclays U.S. Aggregate Bond Index, through July 31, 2016 the 15-year standard deviation was 3.47% on bonds. According to the Wall Street Journal, the standard deviation of the Vanguard Dividend Growth fund, over the same period, was 12.46%. This means the risk on the bonds is about a quarter of the risk on dividend funds.

The current yield on the 10-year U.S. Treasury Bond is about 1.6%. On a fund like the Vanguard Dividend Growth fund, the dividend yield is about 1.9%. Yes, you are getting a higher yield at 0.3%, but at a risk level almost 4 times as high. High quality bonds must pay the same interest rate until the bond matures.  Dividends can be changed by companies for any number of reasons, not the least a decline in earnings that will not sustain the dividend. Many companies are not currently earning as much money as they did last year, and are therefore paying out a higher percentage of earnings in dividends. In some cases, to continue paying the same dividend, companies are borrowing money through the sale of bonds.

Distracted by yields, investors often forget about the risk of investing in equities vs. the risk of investing in bonds. At the present time, the shift of many investors to dividend-paying stocks has resulted in overvaluation of many of these stocks and of the broad stock market. As we approach the end of the third quarter, we will be watching corporate earnings to see if the trend of lessening earnings continues, or if an earnings rebound will take place. If we do not see an increase in earnings, I don’t see how the current increase in stock prices can be maintained. We will also be watching the Federal Reserve to see if they increase the discount rate at their next meeting on September 20th and 21st. Such an increase could have a negative effect on both bonds and stocks over time.

Ed Mallon

September 6, 2016