If there is a consensus opinion for 2014, it is that stocks will continue to outperform government bonds just as they did in 2013. Oddly enough, a couple of the usual fundamental factors, P/E ratios and real interest rates, are signaling investors should be careful before jumping to that conclusion.

With stocks, the most important determinant of return would arguably be the strength of underlying profit growth. On that front, Thomson Reuters recently calculated that 103 companies in the S&P 500 had issued negative guidance on profits compared to just nine that raised profit forecasts—the worst ratio on record. As a result, analysts are rapidly downgrading their fourth quarter profit estimates, but of course, stock prices seem unfazed.

When it comes to returns for government bonds, inflation has generally been the key determinant. The more inflation, the more interest a bond needs to pay in order to compensate for the loss in purchasing power. In 2013, the general trend was falling inflation, but bond yields were rising, not falling as one might expect.

During all of 2012, and much of 2013, real yields (nominal yield minus inflation) on government bonds were negative, meaning that bond yields did not even keep up with inflation. A reversal back to positive real yields had been expected for some time, and now with inflation hovering around 1% and the 10-year Treasury yield back up to nearly 3%, that reversal has arguably run its course. The real yield on the ten-year Treasury is now around 1.7%, which is close to the long-run average real return dating back to 1945. So by this measure at least, bonds are no longer overvalued.

By contrast, one could argue the U.S. stock market is now looking somewhat frothy. Based on the trailing twelve months of earnings, the price-to-earnings (P/E) ratio on the S&P 500 is currently 18.6. This is a full three percentage points higher than historical average P/E of 15.5. Small cap U.S. stocks are even more richly valued with a P/E of over 21.

Despite high valuations, investors continue to shift money out of bond funds and into equities. The assumption is that a stronger economy will translate into higher profits (despite corporations’ recent warnings to the contrary) and that inflation will remain positive but subdued.

Higher profits and low inflation may indeed be the most likely outcome for 2014, but given that stock prices have apparently already priced-in growing sales and profits, a spate a negative reports could send stock prices sharply lower. We are not predicting such a correction, but we do think investors should temper their out-look for equity returns with the knowledge that stocks are fully valued now, and additional price gains in 2014 are likely to come only with rising corporate earnings, not just expanding valuations.

While the real yield on 10-year Treasury bonds may be near its historic average, its nominal yield of roughly 3% is well below its 20-year average of 4.5%. And even though yields have risen, at less than 3%, bonds still represent little competition for stocks in the eyes of return-hungry investors watching the stock market march ever higher. Last summer’s bond market correction, that sent prices tumbling and resulted in negative 2013 returns for bonds, added further credence to those who believe that the time has come to move investment dollars out of bonds and into stocks.

Tactically speaking, it is impossible to know in advance if this will be a profitable strategy, which is why we remind our clients that there are still a number of good reasons to own bonds, even in the current low-yield environment. First, it is very difficult to predict interest rates with any consistency. So even though rates are low by historic standards, and likely to rise in the future, there is nothing to say that this has to happen quickly. In the case of Japan, lending rates have been near zero for the better part of 15 years.

Second, bonds perform differently than stocks. So regardless of what is happening with the rate cycle, there is a real diversification benefit to holding bonds in a portfolio. Diversification typically lowers risk, or volatility, helping to smooth out the ups and downs of individual securities and asset classes.

Finally, for those investors that do like the relative safety of bonds, but are concerned about the damaging effect rising interest rates can have on longer-dated bond values, short-term bonds do offer greater protection. That said, we still maintain that the best bond portfolios are diversified across maturities… regardless of interest rate forecasts.

During the last five years, the annual return on the S&P 500 has averaged almost 18%. In 2013 alone, the stock market was up over 30%. Unfortunately, profits on the S&P 500 are not rising nearly as quickly and are only expected to be up around 6% for 2013. As a result, stocks are now more richly valued than at any time since the financial crisis.

This is not to say that stocks cannot go higher still, but it will likely require an acceleration in corporate earnings growth and the continued flow of favorable economic data. Should either of these falter, share prices are likely to suffer.

Hank Nicholson, CFP
Chief Investment Strategist
The information contained in this blog is general in nature and is intended for informational purposes only. Furthermore, this information should not be construed as a buy or sell recommendation. All expressed opinions are subject to change without notice. Because the facts and circumstances surrounding each investor’s situation differ, you should consult your financial advisor before taking any action based on this information.