Waddell & Reed

Market Perspectives


Valuations and Volatility: Investors may overlook key factors in asset selection

Story Highlights

  • Difference in earnings yields of equities and fixed income is extreme from historical standpoint.
  • Some equities may offer better value now because of high relative bond valuations.
  • Research suggests that simply avoiding volatility may not always be right for investors.
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History shows that many investors simply follow the herd or latch onto a trend. They often chase the asset class that performed well in the past, rather than focusing on the future. Now some have added a pursuit of low volatility as a means to select investments. Individuals with a long-term investment goal, such as funding retirement, may not succeed with such a strategy.

Valuations and investor behavior

At Ivy Funds, we think equities overall remain attractively priced, especially when compared with their historic averages and with other asset classes. U.S. monetary policy continues to be supportive of risky assets such as equities and we think it is likely to remain so for the near future. Conversely, we think fixed-income securities carry risks that may become more apparent when rates eventually begin to rise.

Despite these indicators, investors in long-term mutual funds continue to focus on fixed-income investments. In the nine months ended Sept. 30, 2012, fixed-income funds had inflows of more than $289 billion while equities funds had inflows of $49 billion — including outflows of $2.2 billion in domestic equities funds.1 A concern about risk, volatility or protecting principal may be behind many of these investment decisions.

Fixed-income investments also are a frequent choice as an income source. In the current market environment, equities offer a meaningful alternative. Corporate profitability overall remains high and balance sheets continue to show strength. Many companies again are choosing to use their cash for dividend payments. The estimated 2012 dividend yield of U.S. equities in early October was 2%, compared with the 10-year Treasury yield of 1.7%. 2

One way to assess relative valuations of equities and fixed-income investments is to compare their earnings yields. That might involve a comparison of individual securities in each asset class or representative indexes for each asset class overall. The earnings yield on an investment — also known as its earnings-price ratio — is calculated by dividing the earnings per share by the share price.

The current difference between the earnings yields on equities and fixed income is extreme from a historical standpoint. When the earnings yield on equities is less than the 10-year U.S. Treasury yield, stocks in general may be considered overvalued. Conversely, if the equities earnings yield is higher relative to bonds, equities may be considered undervalued. That is the case in the current market environment. The S&P 500 Index has an earnings yield of about 7%, compared with less than 2% yield for the 10-year U.S. Treasury note. The resulting positive spread in favor of equities — more than 500 basis points — is the highest in almost 40 years.

The data suggest that it may be beneficial to target equities when the earnings yield of the S&P 500 Index is shown to be higher than that of the 10-year Treasury. In the past half-century, there have been four distinct long-term cyclical periods in which the positive spread on equity yields versus fixed-income yields peaked and then eventually hit a trough. Those four periods are shown in the green segments of the chart that follows. During those periods, the average cumulative return for equities (as represented by the S&P 500 Index) was 366%. By comparison, it was 73% for fixed income (as represented by the 10-year U.S. Treasury note). In other words, a hypothetical investment in the S&P 500 Index had a return five times greater than fixed income by investing when the positive spread on equity earnings yields had peaked versus fixed income yields.

Assessing the risks

Although equities typically are more risky than fixed-income investments, we think some equities may represent better value in the current market environment because of the high valuations of bonds now versus their historical levels. While equities may appear to be undervalued now, it also is possible that equities may lose additional value.

The Federal Reserve in late October said it expected interest rates to stay at current historically low levels into at least mid-2015. In our view, rates at these levels mean fixed-income securities carry risks that may become more apparent when rates eventually begin to rise. That would include interest-rate risk, meaning the risk that lower-yielding bonds will be less valuable as rates rise.

We think we are in a period in which monetary and fiscal policy responses will provoke investor behavior in a way that will be favorable for global equity markets.

A look at recent market volatility

Low volatility in a highly popular asset class has indicated in the past that the asset class may have become too expensive when compared to other choices. Consider the performance of the U.S. bond market. In an environment in which interest rates already are very low, the yields on investment-grade bonds again have set record lows in recent months.

For example, the yield on the benchmark 10-year U.S. Treasury note fell below 1.5 percent in July and then rose to only 1.7% by late October. For comparison, from 1992 through 2010, the 10-year Treasury average yield was around 5%. It has not been above 3% since the summer of 2011.3

The low yields in bonds have resulted in high fixed-income valuations. Bond market volatility has reached historic lows as those valuations have continued to climb. When equities showed a similar pattern of low volatility and high valuations, index performance suggests some investors may not have benefitted over longer periods. Consider these examples:

  • The volatility of U.S. equities declined dramatically in 1999 at the height of the tech stock boom. The standard deviation of the S&P 500 Index that year was about 13% — indicating relatively low volatility for equities. The dot-com bubble burst just one year later and the S&P 500 Index lost a cumulative 37.6% by the end of 2002.
  • Conversely, equities volatility increased significantly at the start of the global financial crisis in 2008. In the year that began on Sept. 15, 2008 — the day Lehman Bros. failed — the standard deviation of the S&P 500 Index was up to 54.2%. Then, in the three years that ended on Sept. 14, 2012, the index gained a cumulative 48.7%. During the same three years, the Barclays U.S. Aggregate Bond Index had a standard deviation of 9.2% and a cumulative return of 16.6%. Based on this data, a hypothetical investment in the S&P 500 Index had a three-year return that was about three times that of one in the Barclays U.S. Aggregate Bond Index.

History thus suggests that simply avoiding volatility may not always be the right thing for investors.

Past performance is not a guarantee of future results. Conditions and global market factors that existed at the time of these examples may not represent current conditions, such as the Federal Reserve’s zero interest rate policy anchoring Treasury yields, or the effects of expiring tax breaks and stimulus measures after Dec. 31, 2012.


1 – Source: Strategic Insight 2 – Sources: Credit Suisse, U.S. Federal Reserve 3 – Source: U.S. Federal Reserve

Past performance is not a guarantee of future results. The opinions expressed in this article are those of Waddell & Reed and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 1, 2012, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. The S&P 500 Index is an unmanaged index of common stocks that generally is considered to represent the U.S. stock market. The Barclays U.S. Aggregate Bond Index is a market capitalization-weighted index, representing most U.S.-traded investment grade bonds. Standard deviation is a statistical measure that shows the range of historical returns; it is an indicator of volatility.

Consider all factors. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Dividend-paying investments may not experience the same price appreciation as non-dividend-paying instruments. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for Waddell & Reed Advisors Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

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