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Chart of the Week
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July 6, 2015

Stocks AND bonds—that is the question
S&P 500 earnings yield and Moody's BAA corporate bond yield¹

chart

Source: Bloomberg and S&P Dow Jones, as of 6/29/2015. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • With both stocks and bonds seeing substantial appreciation in recent years, it's more of a challenge to find opportunities to capture unrealized value.
  • By historical standards, stock valuations are somewhat elevated and bond yields remain low.
  • But from a current valuation standpoint, stocks and corporate bonds look similar on a yield basis, with the S&P 500 earnings yield (inverse P/E) at 5.38% and the Moody's BAA corporate bond yield at 5.17%.
  • In addition, both sectors are likely to be impacted by the gradual rise in interest rates that many expect to begin later this year.
  • Investors' best response to such an environment might be gradual as well.
  • Valuations may not suggest a reason to reconsider existing allocations; which is just as well, given that most investor portfolios are built around long-term assumptions and goals in the first place.
  • But they could play into the strengths of active managers that are adept at realizing valuation differences at the individual security level, whether it be in stocks or bonds.
  • Another potential positive: the prospect of a gradually changing interest rate environment could present choices for active managers in both asset classes – orderly reinvestment into higher yielding bonds as rates move up—and into new equity positions as future corporate prospects evolve.

The chart:

  • The chart shows the S&P 500 earnings yield (inverse P/E) and the Moody's BAA corporate bond yield from June 30, 2005 – June 29, 2015.
  • As of June 17, 2015, the S&P earnings yield was 5.38% and the Moody's BAA corporate bond yield was 5.17%.
  • For roughly five years, the S&P 500 earnings yield has exceeded the BAA bond yield, at times by a significant margin, but those yields have converged recently.
  • The wide gap that opened up five years ago was a function of S&P 500 earnings rising faster than the price of the index while bond yields declined. As the price of the S&P 500 began to rise—and as earnings growth slowed in recent quarters—the S&P 500 earnings yield has come down.
  • Meanwhile, the recent rise in market interest rates—note the rise in the BAA corporate yield over the past three months—has helped close the gap even further.

¹ The S&P 500 earnings yield for June 2015 is based on expected earnings of $110.66 for 2Q15 and S&P 500 price of 2,057.64 on 6/29/15. The Moody's BAA corporate yield is as of 6/29/15.


Definitions:

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.

The earnings yield is the earnings per share for the most recent 12-month period divided by the current market price per share.

The price-to-earnings (P/E) ratio is a stock's price divided by its earnings per share.

Moody's Investors Service is a leading provider of credit ratings, research, and risk analysis

BAA is a credit rating denoting a medium grade, moderate risk security.


IMPORTANT INFORMATION:

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

Common stocks generally provide an opportunity for more capital appreciation than fixed-income investments but are subject to greater market fluctuations.

Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

Yields represent past performance and there is no guarantee they will continue to be paid.

This material is for information only and does not constitute an invitation to the public to invest in any funds, securities, strategies or other products. You should be aware that the investment opportunities described should normally be regarded as longer term investments and they may not be suitable for everyone. All investments involve risk, including possible loss of principal. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Past performance is no guide to future returns and may not be repeated. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.

Please note that an investor cannot invest directly in an index. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data. Individual securities mentioned are intended as examples of portfolio holdings and are not intended as buy or sell recommendations. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

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