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Are Stocks a Screaming Buy Relative to Bonds?

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Investors are trying to decipher the actual state of the economy and are applying some basic metrics to figure out which is a better buy.

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In 2010, your money-making friends and neighbors have implemented a simple strategy: buying bonds and selling stocks.

So far, investment-grade corporates, as measured by the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), are up 7%. Long-term US debt, as measured by the iShares Barclays 20+ Year Treasury Bond Fund (TLT), is up 16%. Meanwhile, the SPDR S&P 500 ETF (SPY) -- which includes holdings like Exxon (XOM), Apple (AAPL), Microsoft (MSFT), IBM (IBM), and Bank of America (BAC) -- is down 3%.

Stocks have been under pressure as investors weigh reams of data that point to an economic recovery that remains fragile. Initial claims for jobless benefits are rising and economists are now estimating that real GDP rose just 1% during the second quarter. Central bankers raise the prospect of a Japanese-style deflationary scenario.

The yield on the 10-year note has nose-dived as investors seek safety in government debt, betting on a double dip and deflation. The 10-year bond yield dropped to 2.58% yesterday, a level last seen during the worst of the credit crisis of 2008. (HT: Markman Capital Insight)

All year long, the general investing public has made the same bet: They've been piling into fixed-income securities and showing little love for stocks. As we recently detailed, $203 billion has now been invested in bond funds year to date. In comparison, domestic equity funds have attracted just $16 billion so far in 2010, according to Strategic Insight.

See Our Fixed Income Fascination Continues

Stock market bulls argue that equities are now looking cheap relative to bonds and that its stocks that ring as the asset class with the most potential upside. However, skeptics counter that stocks are cheap because the economic outlook is dire, and they're betting that bonds remain the place to be.

Certainly, by employing some basic measures to compare the relative value of stocks and bonds, equities appear attractive. Dr. Ed Yardeni of Yardeni Research made the case this morning that stocks seem cheap and bonds seem expensive according to a simple model that compares the market's earnings yield to the US Treasury bond yield.

Yardeni first started studying this model after seeing it mentioned in the Federal Reserve Board's Monetary Policy Report to the Congress dated July 1997. The strategist dubbed it the "Fed's Stock Valuation Model" (FSVM), and that's what it's been called ever since.

During the week of August 13, Yardeni says, the forward P/E of the S&P 500 was 11.8. The forward earnings yield, which is just the reciprocal of the P/E, was 8.5%. The 10-year Treasury bond's yield is 2.60% this morning. So its P/E, which is the reciprocal of the yield, is 38.5.

According to the FSVM, that means stocks are 64.8% undervalued relative to bonds.

James Swanson, chief investment strategist at MFS Investment Management, agrees that stocks now look cheap relative to bonds and that, as an asset class, equities boast more opportunity for investors looking ahead.

"There is a big disconnect out there," says Swanson. "People don't want to buy Johnson & Johnson (JNJ), even though it's trading at 12 times expected earnings with a dividend yield of 3.7%."

In short, the stock market is now priced for an economic future that Swanson thinks remains unlikely. "This only makes sense if the world is going into a deflationary scenario," the strategist says. "Otherwise, this is a mispricing."

Of course, individual investors might not care whether stocks are cheaper relative to bonds. Perhaps, after two bear markets and 12 years of a stock market that's gone nowhere, they're no longer interested in padding their portfolios with equities, regardless of how much of a relative bargain they might appear.

But Swanson's point is that while this shift might be true of the public, much of the money out there is in the hands of big institutional players -- the pension funds, for example -- and those investors are measured by relative performance.

"There is almost no way they can now get a lot of capital appreciation out of the bond market from here," says Swanson. "They have to beat certain indexes. I think they will be back."

Swanson says he generally favors putting money to work right now in large-cap stocks, Tech-oriented companies, and dividend payers.

Other market pros take another approach: Yes, stocks might look cheap relative to bonds, but that's because the economic outlook remains bleak. Mike Shedlock, a well-known registered investment adviser for Sitka Pacific Capital Management, argues that the economy is already mired in deflation, a dangerous downward spiral in prices that will prove lethal for corporate profits.

"Why are Treasury yields low?" Shedlock asks. "It's because the economy is in recession."

Furthermore, Shedlock argues that investors are ultimately best advised to judge the two asset classes independently. "It is important to evaluate stocks based on normalized earnings estimates and bonds based on default and inflation risks," he says. "Comparing stocks to bonds is simply an invalid comparison."

Shedlocks points out that equity market valuation measures still look rich. The Shiller P/E ratio, for instance -- which uses a 10-year average of inflation-adjusted earnings -- still points to a market that's about 20% overvalued.

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