How Cash Could Point to More Upside for U.S. Stocks
Investors remain concerned about dwindling bond yields – but still aren’t rushing headlong into stocks, notwithstanding their recent market highs. We thought it might be interesting to take a look at the difference between the cash earnings yield of U.S. stocks (as represented by the MSCI U.S. Stock Index) and the yield being paid by intermediate-term investment grade corporate bonds. In looking at historical data, cash earnings yield can be a good proxy for free cash flows – and an indicator of a company’s financial strength.
Cash Earnings Yield of U.S. Stocks vs. Yield on Investment Grade Corporate Bonds
Source: Ned Davis Research Group, 1/31/1973 to 1/31/2013. Copyright 2013 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. SeeNDR Disclaimeranddata vendor disclaimers. BC=Barclays Capital
The spread between these two figures has been unusually wide for the past few years. It takes more than low bond rates to produce such wide spreads. It’s also the result of hefty cash earnings yields.
Cash Earnings Yield Minus Bond Yield at 7.44% as of 1/31/2013
Source: Ned Davis Research Group, 1/31/1973 to 1/31/2013. Copyright 2013 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. SeeNDR Disclaimeranddata vendor disclaimers.
We’re taking particular note of this situation now because it has persisted even as stocks enjoyed a significant run in 2012 and so far in 2013. Free cash flows appear to have kept pace with stocks’ uptrend, giving us confidence that stocks can support further movement to the upside.
Companies have been able to generate robust free cash flows largely because of their conservative approach during the period of moderate economic recovery since 2009. Corporate balance sheets, with lower debt and lots of cash, are quite strong today, positioning firms to enrich shareholders through stock buybacks and dividends. Free cash flow and cash on hand also enable the strategic acquisitions and vital long-term capital investments that can help grow a business.
Free cash flows could be both an indicator of companies’ value and fuel for their future growth. They also illustrate how, in today's environment, the disparity between stocks and bonds is near historic proportions.
Past performance does not guarantee future results.
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