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Are Stocks Now Safer Than Bonds?

Jeremy Glaser
Heather Brilliant, CFA

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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Glaser: You have that interest-rate risk, so even if certainly stocks aren't maybe going to have quite the returns even if you would've bought them a few years ago, you still think you are going to be better-off in that asset class, choosing wisely versus being in Treasuries?

Brilliant:  I think so, and you've heard a lot of people talk about how we are in a period of deleveraging and how there's not going to be a lot of economic growth. That certainly is one possible outcome. But it's also possible, and we are seeing quite a lot of signs, that the economy is starting to improve. As we start to see some economic recovery, that can cause inflation to start to ease up as well, which puts a lot of pressure on interest rates to go up.

Even if that scenario doesn't play out, the U.S. government has quite a lot of deleveraging to do. We are an extremely leveraged country. You can literally look at a chart that compares our leverage, our debt/gross domestic product ratio, and the only countries where the debt/GDP ratio is higher are the four countries in Europe that are most in trouble right now. Unfortunately, they can't print their own money. But the U.S. can, and everyone knows that that's a possibility, so we don't see the same discounts when it comes to the U.S.

What that means is that if it comes to that, if the U.S. does decide it needs to print its way out of this crisis, then you will see inflation move up by definition, and that will put a lot of upward pressure on interest rates. In that case, I would much, much rather own stocks than bonds.

Glaser: We certainly are seeing some signs of economic recovery, but it's not particularly even. You know, we heard from the Federal Reserve in the minutes from Federal Open Market Committee's last meeting that there is a lot of discussion about the labor market still being weak and the potential for growth to remain incredibly slow. They seem committed to keeping rates low, at least through 2014. If you know that they are at least saying they're going to do that, does it still make sense to shy away from some of those fixed-income investments right now?

Brilliant: I still think the commitment is to keep rates low, not to bring them any lower, and I think that was pretty clear. Of course, the Fed has every opportunity at least once a quarter to change its mind altogether. So, if Fed officials start to see the economy coming in stronger than they've been expecting, then you will see them reverse that position right away.

Now, all that being said, it's still very clear to me that the risk/reward profile is in favor of stocks versus bonds because even if rates stay where they are now, you can get more return in stocks if you're really careful about where you pick your opportunities.

Glaser: So, even though bonds are sometimes seen as a less risky asset, in this case it might actually be the reverse?

Brilliant: That's my opinion, yes.

Glaser: Even if they may seem a little bit riskier, one of the reasons that people are in fixed income is for the income. For example, you could be a retiree and need that paycheck. What do stocks have to offer there? What do dividends look like with respect to yields right now?

Brilliant: So, during the last 15 years, and really even longer if you go back and look at history, the yields on bonds have gone nowhere but down. So, while corporate spreads have certainly moved around a lot, the overall yields have literally come down steadily for the last 15 years. On the flip side, you've seen dividends and dividend yields ease upward over that period, where in some cases now, you're finding stocks with better returns than the corresponding bonds can offer. So, in that case, we think it makes a lot of sense [to invest in stocks over bonds].

It's really important to keep in consideration, however, that it is much riskier to own a stock and its dividend yield than to own a bond. The bond is about repayment and about getting that return of principal and interest. whereas in the stock market, in 2008, literally 20% of companies cut or reduced their dividend in some way. So, it's riskier, but we think in this environment where there's more risk to the upside than the downside, we think that's a risk worth taking.

Glaser: Well, Heather, thanks so much for your thoughts today.

Brilliant: Thanks very much for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.