Stocks lose allure with highest valuation to bonds since ’11

Valuation Techniques

Stock earnings yields and bond rates are both valuation measures, showing how much owners are getting back in profits or interest payments on the money they invested. Income generated by S&P 500 companies hasn’t fallen below Treasury rates for more than 11 years. The advantage for stocks was close to its most bullish level ever in 2012, according to data compiled by Bloomberg.

“At this point, equities are so highly valued that it’s very hard to assume that there’s going to be much more rotation” from bonds to stocks, Daniel Alpert, founder and managing partner at New York-based Westwood Capital LLC, said in a Jan. 6 Bloomberg Radio interview with Tom Keene. “Cash is a wonderful place.”

Walter Todd, chief investment officer at Greenwood Capital Associates LLC, says he’s keeping more new money in cash than he did three to six months ago as he braces for a decline in equities. Thornburg Investment Management Inc.’s Jason Brady is buying bonds more aggressively, while Huntington Asset Advisors’ Sorrentino is selling call options, a bet stock gains will be limited, to finance the purchase of protective puts.

More Defensive

“We are being more defensive going into this year,” Sorrentino said.

U.S. pensions, which control $16 trillion, shifted out of equities and into bonds in the third quarter at the fastest rate since 2008, latest data compiled by the Federal Reserve show.

Comparing earnings and bond yields is similar to an indicator known as the Fed model, derived by U.S. economist Edward Yardeni from a July 1997 report by the central bank. Critics such as AQR Capital Management LLC founder Clifford Asness have contended the technique doesn’t work because inflation affects stock valuations and interest rates differently.

Earnings for New York-based Alcoa represent about 3.2% of the stock price, down from 12.2% at the start of 2012, data compiled by Bloomberg show. The largest U.S. aluminum producer reported last week that fourth-quarter profit missed analysts’ forecasts, sending the shares down 5.4% the next trading session.

Tyson Foods, the largest U.S. meat processor whose shares climbed the most in 27 years last year, has an earnings yield of 6.4%, almost half what it was a year ago, according to data compiled by Bloomberg.

Shares of Harris Corp., the Melbourne, Florida-based communications equipment company, will slip about 15% this year after rallying 43% in 2013, analysts estimate. The pessimism comes after the earnings yield slipped to 7.2% from 11.7 in April and as profits are forecast to drop 3%, data compiled by Bloomberg show.

Vulnerable Market

“For prices to keep going up, you need better and better news,” Brady, a money manager who helps oversee $95 billion at Thornburg, said in a Jan. 8 telephone interview from Santa Fe, New Mexico. Brady manages funds invested in both equities and credit. “This market is very vulnerable.”

Smaller spreads are nothing to be concerned about because the relationship still favors equities, and corporate earnings will keep the rally going, according to Howard Ward, the chief investment officer for growth equity at Rye, New York-based Gamco Investors Inc., which oversees about $40 billion.

“It suggests stock returns won’t be as outstanding relative to bonds,” Ward said in a Jan. 7 interview. “But stocks will remain the only game in town.”

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