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By Jeremy Glaser and Heather Brilliant, CFA | 04-05-2012 01:00 PM

Are Stocks Now Safer Than Bonds?

Morningstar's Heather Brilliant says the risk/reward profile for bonds is no longer in investors' favor, and stocks still offer better return potential despite the recent runup.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the stock market looking almost fully valued, should investors be shying away from equities? I am here today with our vice president of global equity and credit research, Heather Brilliant, to answer this question.

Heather, thanks for joining me today.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: So let's take a look at valuation first. We're a little bit more than three years now from the market bottom in 2009. Where are stocks sitting?

Brilliant: Well, right now, we think they are pretty close to fairly valued. They are just a hair under fairly valued, if you look across all of our coverage universe. At the bottom of the financial crisis, we had about 60% of equities having Morningstar Ratings for stocks of 5 stars. Now, we have literally 60 stocks--out of 1,800--that are trading at 5 stars. So, it is a lot harder to come across supercheap opportunities right now.

Glaser: Without seeing huge discounts and huge margins of safety, you've talked before that when you buy a stock, you really want that margin of safety there. This is because if something goes wrong, if things don't go exactly as you expect, you can still get a decent return out of that. But now for the market as a whole, that margin of safety is gone. Does that mean that stocks really should just be something that you avoid? Should people be looking at alternative investments instead of a traditional stock fund or a traditional stock portfolio?

Brilliant: Not in my opinion. I think there are still a lot of opportunities within stocks. You just have to be willing to dig to that next level of depth. It's hard to just look at stocks as a whole, and say that there's a lot of opportunity generally speaking. But if you start digging into some of the sectors, such as energy or basic materials, there are actually quite a lot of opportunities to be uncovered.

Glaser: It sounds like it certainly pays to be selective. But a lot times, investors are not just deciding where to allocate money in equities, but they are also wondering whether they should be in equities or in fixed income, or even be looking at some other different types of places where that money can go, maybe just even cash. How do you think about stocks in relation to something like bonds right now?

Brilliant: That is a really good question, Jeremy, and you've seen a lot of fund flows just pouring into bond funds. And it's something that I think is a bit of a red flag at this point because if you look at the history of interest rates, we have a chart that literally shows that interest rates have done nothing but go down during the last 10 years. I don't think that's a shock to anybody watching this video. But the fact is, at this point, we really think that interest rates in general have nowhere to go but either flat or maybe even start to go up. So, are we saying interest rates are going start going up tomorrow? No. But are they going to start going up before they start going down? We think so. So the risk/reward is no longer in investors' favor to be pouring money into, especially, Treasury-oriented bond funds.

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