RELATIVE VALUE, ACCORDING TO MR. MARKET

By Annaly Capital Management:

File this blog post under J for “Just Wondering.” In this case, we just wonder about the relative value decisions of Mr. Market at this particular point in time. You know Mr. Market, he is the anthropomorphic metaphor created by Benjamin Graham, the father of value investing, to explain the gyrations of the market. As Graham wrote, “Imagine you had a partner in a private business named Mr. Market. Mr. Market, the obliging fellow that he is, shows up daily to tell you what he thinks your interest in the business is worth.” Mr. Market doesn’t explain his reasoning for why it is worth X one day and Y the next, but that is what we mere mortals have to try and figure out. To take Ben Graham one step further, Mr. Market prices each asset not only against itself every day, but against other investments as well. Which brings us to the graph below:

We plotted the income returns to stocks, bonds and gold. At last count, stocks have a dividend yield of just below 2%, the 10-year Treasury yields just above 3%, and the barbarous relic yields what it always yields, zero. If an investor is looking at the major investment classes for income, there is not much else to choose from. In the aggregate, emerging market debt is yielding 7.6%, and high yield debt is currently yielding about 9.2%. In nominal terms, all these numbers are at or around their historical lows, although in relative terms the story is a little different. For emerging markets and high yield, the spreads to Treasuries have been wider and they’ve been narrower. At zero, gold is not as disadvantaged as it usually is.

As for stocks versus the 10-year Treasury, the historical relationship has gone through a sea change in the last 60 years or so. Prior to June 1957, stocks always out-yielded bonds. Both asset classes are considered long duration (one could argue nothing is as long as a common stock), so the yield difference could be chalked up to differences in perception of risk. Before Mickey Mantle won his second MVP, stocks had a higher yield than Treasuries, perhaps to reflect both the greater risk associated with the asset and the fact that stocks were not dependable generators of capital gains. Since then, bond yields have risen and fallen, but stock yields have mostly been lower. For a few months in the first half of 2009 the relationship reverted to the Eisenhower era, but not for long. (For a historical look at the importance of dividends in total return, please see our white paper “In Praise of Dividends.”)

With such puny yields on offer in most parts of the capital markets, an investor has two choices: First, accept the fact that we are in a low-yield environment. This is hard for most investors to do. They are beholden to a predetermined return hurdle or are slaves to the persistent memory of recent experience. Second, seek out investments that have a greater propensity for capital gains or higher yields in order to increase total return. For this we have to ask Mr. Market where he believes this growth will come from. In his heart of hearts, does he think US equities will be better than range-bound for the next five or ten years? Higher yields can be found, but we add the following advice for Mr. Market: Make sure your return expectations are risk-adjusted.

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