Updated: Feb 16
As I mentioned in another article, the US equity market took a bullish turn at the start of 2023. The negative sentiment about a recession that almost every analyst agreed would occur has evaporated from the pages of the financial media. The brave investors who run their own money, and advisors of the ones who don't, are feeling the temptation to jump back in as the price action improves.
Quick Non-legal Disclaimer: This information is for readers who manage their own investments as well as those who entrust that role to a financial advisor. In my view, most people should have a financial advisor. Just as I do not have the expertise to repair my own engine or perform surgery on my own organs, most people do not have the knowledge or time to manage their own nest egg in an intelligent way. This content will help you to ask your advisor the right questions. Professionals in this sector should always have a thesis on whether assets are cheap or expensive (explained below), and should be equipped to get you greater diversification than the two most heavily invested asset classes: broad market stock indices and bonds. Like a doctor, they should also be abreast of the latest research in the field.
Dark blue - S&P500 index, light blue - Dow Jones Industrial Average, Orange - NASDAQ
This should go without saying, but "number go up" is never a good reason to buy risk assets. The one exception is when the investor is adhering to a specific set of trend-following rules. Equity prices should be grounded in something real, like earnings or tangible assets, and should be stacked against other investments with different levels of risk.
At the February 9th closing price of 4,098, the S&P 500 long run earnings yield is 2.9 percent. A variation of the Price-to-earnings ratio, this means spending $100 on S&P index stocks gets the investor $2.90 of 10 year average earnings. There are no indicators or ratios that will perfectly predict stock returns in the real world, but history makes it clear that you're more likely to see your stock holdings appreciate if you buy them at a high earnings yield (aka a low Price to Earnings Ratio).
The object of this game is to buy low and sell high, not buy high and pray you get to sell higher. No matter the price action of a particular asset class (US stocks rebounding in 2023, for example), investors and advisors should always ask themselves the question, "How does this compare to other investments with less risk?" It's difficult to compare stocks to bonds and money market funds, but earnings yield (explained above) is one way of doing that, as recommended by Benjamin Graham in his 1949 book, The Intelligent Investor.
Graham's recommendation was to buy stocks with an earnings yield no less than twice the prevailing interest rate on AAA rated corporate bonds. That was a lot more realistic in 1949 than it has been in the 2010s and 2020s, but we certainly would not want to accept an earnings yield below prevailing interest rate on highly rated bonds. From 1970 to 2009, corporate bonds in this category had a default rate of 0.5 percent. This 40 year period includes the fallout from the Great Financial Crisis, as well as the bond market bloodbath that came as a result of the Fed's 1979 rate hikes. As of February 9th, AAA corporate bonds are yielding 4.4 percent interest, a full 1 1/2 percent higher than the S&P 500 earnings yield, with far less risk.
Moody's Ratings AAA bond yield from 1919
But there are even easier ways to take advantage of these interest rates than buying bonds. A few clicks in your brokerage account will bring up the prevailing rates on Certificates of Deposit at large and small US banks. There are several banks that will pay you 4.5-4.55 percent annualized interest to borrow your thousand dollars for three months. If you're confident that you won't need the cash for a couple of years, they will pay 4.85 percent annually to borrow it for that timeframe. Even Uncle Sam will pay about 4.7 percent to borrow your money for three months, should you buy a US Treasury Bill.
Lastly, at the very bottom of the risk curve, are Money Market Mutual Funds. For the last two years, MMMFs have been plowing much of their investors' cash into the Federal Reserve's overnight reverse repo facility. The Fund takes your thousand dollars, lends it to the Federal Reserve Bank of New York overnight, then continues to roll it over every single day. This facility currently pays 4.55 percent, and you can pull out of the fund at any time.
In summary, after a decade and a half of rock bottom interest rates, there is finally a halfway decent return to be had in low risk investment vehicles. US equities simply have not fallen enough from their recent highs to justify allocating capital to them. Even at the lows of 2022, the earnings yield on the S&P index was 3.15 percent, less than the prevailing bond yields at the time of 5 percent.