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Yield to Opportunity

After falling more than 5% from its peak through October 10, the S&P 500 went through an even scarier roller-coaster ride during the week of October 17 that saw an intra-day peak-to-trough decline of 4.8%, as investors were overwhelmed by with a “What-if” mindset: What if Ebola ends up spreading out of control and becomes the 21st century version of the Spanish Influenza? What if ISIS turns Iraq into a new terrorist state, like North Korea, only more aggressive toward the United States? What if Europe not only falls into a triple-dip recession, exacerbating China’s slowdown and slowing the US’s recovery, but also gets sucked into a deflationary spiral? And what if the new leadership in Greece allows itself to fall off of the bailout repayment wagon? These questions are very hard to quantify, which added intensity to the uncertainty.

At the same time that stocks were stumbling, the yield on the 10-year Treasury bond resumed its tumble, trading below the 2.0% threshold for the first time in more than a year after flirting with the 2.6% level of only a month ago. Yet investors perpetually weigh opposing opportunities. So when the dividend yield for the “standard for stocks” approximates that of the “benchmark for bonds,” investors have historically concluded that stocks represent the greater opportunity. Indeed, since 1953, whenever stocks yielded more than bonds, the S&P 500 gained an average 19% in the coming year, and recorded a price advance 81% of the time. What’s more, whenever the yield on the 500 traded within one percentage point of that for the 10-year bond, the S&P 500 gained an average 13%, and rose in price 85% of the time. However, as bonds offered an increasingly attractive alternative to stocks, the average price gain and frequency of advance declined for the S&P 500.

So there you have it. Global tensions are on the rise from ISIS to Ebola. In addition, investors worry that the economic malaise contagion in Europe will infect interacting global economies. Yet the yield differential between stocks and bonds implies that an opportunity has emerged for equity investors. Even though stocks may have to re-test recent lows, history hints that because the dividend yield on the S&P 500 is within one percentage point of that for the 10-year Treasury bond, there is an increased likelihood of a positive performance for equities in the coming year.

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