Weighing the Stock/Bond Trade-Off

Summary:

Weighing the Stock/Bond Trade-Off

At LPL Research, we started the year bullish on stocks and the market bounced back as expected. However, we have recently turned more cautious on stocks for some very good reasons. At this time, we believe bonds are more attractive when it comes to the potential risk/return trade-off for investors.

In this latest edition of LPL Street View, we will take a quick look at why our Strategic & Tactical Asset Allocation Committee has arrived at this assessment and highlight a couple of charts to help explain.

A Bit Cautious on Stocks

At this time our Committee is suggesting investors should maintain a benchmark weight to their equity exposure, meaning we are neutral, but not necessarily bearish, on equities.  This represents our belief that the risk-reward tradeoff between equities and bonds is roughly balanced with stock valuations elevated and bonds offering very attractive yields.

To highlight this fact, let’s take a look at the equity risk premium. The equity risk premium can be defined as the extra return investors can hypothetically expect to earn from the equity asset class based on the additional risk investors are taking when they choose stocks over bonds. The current equity risk premium, as shown here, is near zero, telling us investors may not get an attractive return for taking on equity risk. This is one of the variables we are considering when we say we are cautious on stocks at the moment. Other variables we are considering include the likely further deceleration in the economy and the onset of what is expected to be a unique U.S. political backdrop over the next 15 months. It’s election season now, and stocks typically do not fare well in election season.

But “Pounding the Table” on Bonds

Let’s switch gears. While we are neutral on equities, we do believe the bond market is presenting a unique opportunity for investors…particularly income-oriented investors. We are suggesting investors overweight bonds relative to their tactical benchmarks. Why is that?

Importantly, prevailing bond yield levels, in our view, are the best predictor of long-term bond returns. Right now current yields are at levels last seen over a decade ago, indicating there may be tactical opportunities to increase bond exposure. Simply stated, we like bonds here, and we believe investors do not need to take on undue equity risk because bond yields offer such an attractive alternative for their investment dollar.

Highlighted in this chart the Bloomberg Aggregate Bond Index, which represents the most stable areas of the bond market, offer a current yield of approximately 5%. Across the board, those prevailing bond yields we mentioned are attractive and investors do not have to take on much credit risk to get access to potentially good fixed income returns. 

Let’s sum it up…we are suggesting that the return/risk tradeoff in core bonds is more attractive than equities at this juncture. Period. And if you are an income oriented investor, when have bond yields been this good?  It has been a long time…….Take advantage of it.

Thanks for listening… and as we always say at LPL Research…allocate wisely.

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