Stocks May Be Safer Than Bonds at this Point

By on October 26, 2010

Brett Arends of The Wall Street Journal thinks investors are crazy. He reasons that bond yields currently can’t compete with stock yields, but investors keep shoveling money into bonds. Arends uses Wal-Mart as a prime example:

Take a look at the bond issue. Wal-Mart sold $750 million worth of three-year bonds paying 0.75% a year. It sold $1.25 billion of five-year bonds paying 1.5%, $1.75 billion of 10-year bonds paying 3.25% and $1.25 billion of 30-year bonds paying 5%.

Remember that those bond coupons are subject to two hidden costs. First, bond interest is taxed as ordinary income. That means that if the bonds are held in a taxable account, they will be taxed up to 35% right now — and as high as 39.6% next year if the Bush tax cuts expire as planned.

Second, bonds face a serious risk from inflation. Who wants a piece of paper paying 5% a year for 30 years if inflation jumps to 7%? Nobody. If that happens, the price of the bond would plummet.

Now let’s take a look at Wal-Mart stock.

At $54, it has barely moved over the past 10 years. Yet during that time the company’s annual sales and net income have more than doubled. Net operating cash flow has nearly tripled. And dividends have quadrupled, from 24 cents to $1.09.

Okay, so it was overvalued a decade ago. Today it’s 13.5 times forecast earnings. And the dividend yield is 2.2%.

It’s not a king’s ransom, but it’s better than you’re getting on those three- and five-year bonds, and not that far behind the yield on the 10-year.

Wal-Mart has raised dividends by an average of 16% a year over the past decade. If it merely raises them by 10% a year in the future, the yield on the stock will surpass that on the 10-year bonds within about five years. It will surpass that on the 30-year bonds within 10 years.

The company could raise those dividends more quickly if it chose. Its dividends are easily covered by its earnings and cash flow. And it is currently spending billions more buying back stock to boost investors’ returns.

Arends questions the intelligence of investors:

What we are seeing is merely one example of the very “dumb” process by which so many ordinary members of the public invest their money. The problem is that they, and their advisers, are apt to separate “asset allocation” from investing — in other words, they first decide to invest in bonds and then send money to a bond fund. The hapless bond fund manager then has to go out and “put that money to work,” even in an overvalued market.

Source: The Wall Street Journal

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