This is a simple concept. But nobody these days seems to get it.
Money flows where it’s treated best. Just as the cream rises to the top, money will always move toward the highest potential returns.
So where is it treated best now? Let’s take a look…
Right now, you’re being punished in most places that you put your money. You’re earning…
- 0% in the bank
- 2% in government bonds
- 5% in corporate bonds
Inflation is currently running at 3.5%. When you take that into account, you’re either barely keeping up or you’re falling behind.
How do stocks fit into the mix? Darn well, at the moment… Based on relative values, stocks should more than double from here.
The key factor to understand is something called “earnings yield.”
Earnings yield is not something complicated… It is the price-to-earnings (P/E) ratio reversed. It is the E/P ratio. And it allows us to compare stocks to those other assets in an apples-to-apples way.
Right now, the S&P 500 stock index is trading at around 1,200. Analysts estimate earnings for the S&P 500 will be around $100 next year. The forward P/E for the stock market is about 12 (that’s 1,200/$100). So the earnings yield for the stock market is about 8.3% (that’s $100/1,200).
Traditionally, the earnings yield on a company’s SHARES is lower than yield on that company’s BONDS. This makes sense. Stocks have dramatic upside potential that bonds don’t…
For example, if you buy a new five-year corporate bond today paying a 5% yield, the best you can do is earn 5% a year over five years. But if you’re buying shares of that company’s stock, you have the prospect of bigger returns on your money as that company grows. So you may be willing to buy at an earnings yield of just 4%.
With corporate bonds yielding 5%, the earnings yield on stocks should be 4% – or less – because of the extra upside stocks offer.
Throughout the 1980s and 1990s, this relationship held, though the numbers were a little different. If corporate bonds paid 10%, it was a good deal to buy stocks when the earnings yield was 8% (which would have been a P/E ratio of 12.5).
Stocks got extremely overvalued around the year 2000… when the earnings yield on stocks fell to 3% (a P/E ratio of over 30) while corporate bonds paid 8%. That was too big a “spread” between the two yields.
Today, we have the opposite situation… The earnings yield on stocks is 8.3%. Meanwhile, corporate bonds are paying about 5%. This is a never-before-seen extreme, in favor of stocks.
One thing that could get this relationship back to normal is if corporate bonds crash. But I don’t see that happening. When Treasury bonds pay 2% interest, earning 5% in corporate bonds is attractive.
The other thing that could “fix” the relationship is for stock prices to more than double.
The earnings yield on stocks is at the highest premium over corporate bond yields since the last Great Bull Market in stocks started in 1980.
Is the next Great Bull Market in stocks about to start now? I don’t know. We still don’t have an uptrend to hang our hats on. I don’t know when the next great bull market will start. But I do know one thing… the setup conditions are in place.
It might not seem like it… But money is treated better in stocks right now than in any other place. The earnings yield is just too high to ignore. Money will eventually flow to where it’s treated best… and that’s in stocks.
Be patient and wait for an uptrend in stocks. Then get on board…