Are Stocks Still A Bargain?

With global stocks up approx­i­mately 25% from their Fall 2011 low and many market watchers from various financial media sources endorsing equities in recent weeks, it’s hardly sur­pris­ing that investors are won­der­ing if stocks are still a good bargain.

While some mea­sures of sen­ti­ment – notably abnor­mally low volatility levels – could be inter­preted as flash­ing yel­low cau­tion signs, val­u­a­tions and fun­da­men­tals still favor global stocks over the long term.

Cur­rently, equi­ties look rea­son­ably priced on an absolute basis. Devel­oped mar­ket equi­ties are trad­ing at around 14.5x trail­ing earn­ings, while large emerg­ing mar­kets are trad­ing at roughly 12x earnings. These val­u­a­tions are sig­nif­i­cantly above those touched dur­ing last year’s trough, but both emerg­ing and devel­oped mar­ket stocks are now trad­ing at a significant discount to their long term averages.

The rel­a­tive case for stocks, how­ever, is even more com­pelling as equi­ties look very cheap com­pared to bonds. While equity val­u­a­tions are mod­estly below their long-term aver­age, bond val­u­a­tions are sig­nif­i­cantly above theirs when mea­sured by vir­tu­ally any metric.

Nowhere is this more evi­dent than in the U.S. Treasury Market. Late last year, the yield on the 10-year Trea­sury note dipped below the level of core infla­tion for the first time since 1980. Rather than pay­ing investors the typ­i­cal long-term aver­age real yield of 2.5% to 3%, the US gov­ern­ment is now pay­ing a neg­a­tive real yield to bor­row. As a result, unless the US is slid­ing toward Japan­ese style defla­tion – and so far there is lit­tle evi­dence of this – US Trea­suries look extremely expen­sive and investors in 10-year notes are accept­ing a loss in pur­chas­ing power and no real income. In addi­tion, because coupons are so low, the dura­tion or inter­est rate risk of Trea­suries is at or near a his­toric high.

Some investors have weighed the volatil­ity of stocks against the low yield on bonds and opted for a third choice: Cash. A tac­ti­cal move into cash is cer­tainly rea­son­able for brief peri­ods of time. But if you’re wor­ried about long-term pur­chas­ing power, hav­ing a sig­nif­i­cant, long-term allo­ca­tion to an asset pay­ing zero return makes lit­tle sense. Stocks are a more rea­son­able option to consider.

To be sure, invest­ing in equi­ties has its risks. Some have argued that equity val­u­a­tions are flat­tered by his­tor­i­cally high mar­gins. But in the United States at least, a com­bi­na­tion of just enough gross domes­tic prod­uct growth, ane­mic wage growth and low rates should support margins over the near term.

Among other risks, while US defla­tion looks unlikely, it’s pos­si­ble and it’s a sce­nario that would clearly favor bonds. Under the oppo­site sce­nario – higher US inflation – equi­ties would surely suf­fer thanks to lower mul­ti­ples. How­ever, in an infla­tion sce­nario, equi­ties would likely hold up bet­ter than bonds or cash.

In short, equi­ties may not offer the stel­lar prospects of the 1980s or 1990s, but absent a bout of defla­tion, stocks are likely to out­per­form the alter­na­tives over the long term.