Sunday, September 17, 2006

What Yields Tell Us About Equities

A little while back, my wife and I received notice that one of our certificates of deposit was going to mature. We considered all the options for the funds: buying a new car, putting the money in a retirement savings vehicle, adding to college savings, investing in stocks, etc. In the end, we found a promotional money market account at a local bank that guaranteed us well over 5% on liquid capital. We went with that, opting for flexibility above all.

On a very small scale, my wife and I experienced what markets go through daily: calculations regarding how much reward to pursue for a given amount of risk. There are times when guaranteed return of capital becomes more important than absolute return on capital and investors take the bird in the hand. Other times, it makes sense to pursue those long-term returns on equities, drawdown periods and all.

The chart above covers the period from 1982 to the present. I tracked the weekly dividend yield of the S&P 500 Index and the yield on 1-year Treasury Bills. I computed a 52-week moving average of the difference between the Bill yield and stock index dividend yield and then looked at how far above or below that moving average we were in yield percentage terms.

What that gives us is a relative sense for when fixed income is more attractive (Bills give us more yield relative to stocks compared to the 52-week average) and when stocks are more attractive (stocks give us more yield relative to Bills compared to the 52-week average).

When the Fed tightens credit, those bill yields rise sharply and provide competition for stocks. Note how those rising periods leading up to peaks preceded some nasty market drops in 1983, 1987, 1990, and 2000. (We had a relatively benign market drop in 1994).

When the Fed eases, Bill yields plunge and stocks provide competition for fixed income. Note how the troughs on the chart occur at some nice times to have owned equities, including the recent market bottom in 2002.

Notice that, recently, fixed income has provided good competition for stocks (hence our household decision). Notice also that, with the recent decline in yields, that competition is lessening. Should we see weak economic statistics going forward and actual Fed easing of rates, we will once again visit the territory below the zero line. And that might lead our family to a different allocation of capital.

PS - My bad: Chart heading should read 1-Year T-Bills, not Notes. I originally looked at Note data, but stuck with Bills to better reflect Fed impact on short rates.