Are Stocks Still A Bargain? (IOO, ACWI, ACWV)

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March 29, 2012 2:07pm NYSE:ACWV NYSE:IOO

Russ Koesterich:  With global stocks up approximately 25% from their fall low and many market watchers endorsing equities in recent weeks, it’s hardly surprising that investors are wondering if stocks are still a good bargain.

While some measures of sentiment – notably abnormally low volatility levels – could be interpreted as flashing yellow caution signs, valuations and fundamentals still favor global stocks over the long term.

Currently, equities look reasonably priced on an absolute basis. Developed market equities are trading at around 14.5x trailing earnings, while large emerging markets are trading at roughly 12x earnings. These valuations are significantly above those touched during last year’s trough, but both emerging and developed market stocks are now trading at a significant discount to their long-term averages.

The relative case for stocks, however, is even more compelling as equities look very cheap compared to bonds. While equity valuations are modestly below their long-term average, bond valuations are significantly above theirs when measured by virtually any metric.

Nowhere is this more evident than in the US Treasury market. Late last year, the yield on the 10-year Treasury note dipped below the level of core inflation for the first time since 1980. Rather than paying investors the typical long-term average real yield of 2.5% to 3%, the US government is now paying a negative real yield to borrow. As a result, unless the US is sliding toward Japanese style deflation – and so far there is little evidence of this –US Treasuries look extremely expensive and investors in 10-year notes are accepting a loss in purchasing power and no real income. In addition, because coupons are so low, the duration or interest rate risk of Treasuries is at or near a historic high.

Some investors have weighed the volatility of stocks against the low yield on bonds and opted for choice C: Cash. A tactical move into cash is certainly reasonable for brief periods of time. But if you’re worried about long-term purchasing power, having a significant, long-term allocation to an asset paying zero return makes little sense. Stocks are a more reasonable option to consider.

To be sure, investing in equities has its risks. Some have argued that equity valuations are flattered by historically high margins. But in the United States at least, a combination of just enough gross domestic product growth, anemic wage growth and low rates should support margins over the near term.

Among other risks, while US deflation looks unlikely, it’s possible and it’s a scenario that would clearly favor bonds. Under the opposite scenario – higher US inflation – equities would surely suffer thanks to lower multiples. However, in an inflation scenario, equities would likely hold up better than bonds or cash.

In short, equities may not offer the stellar prospects of the 1980s or 1990s, but absent a bout of deflation, stocks are likely to outperform the alternatives over the long term. Possible iShares solutions include the iShares S&P Global 100 Index Fund (NYSEARCA:IOO), the iShares MSCI ACWI Index Fund (NASDAQGM:ACWI) and the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA:ACWV).

Source: Bloomberg

The author is long IOO.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. An investment in stocks, bonds or ETFs is not equivalent to and involves risks not associated with an investment in cash.

Written By Russ Koesterich From The iShares Blog

Russ  Koesterich, CFA, is the iShares Global Chief Investment Strategist as well as the Global Head of Investment Strategy for BlackRock Scientific Active Equities. Russ initially joined the firm  (originally Barclays  Global Investors) in 2005 as a Senior Portfolio Manager in the US Market Neutral Group. Prior to joining BGI, Russ managed several  research groups focused on quantitative and top down  strategy. Russ began his career at Instinet in New York, where he occupied several  positions in research, including Director of Investment Strategy for  both US and European research. In addition, Russ served as  Chief North  American Strategist for State Street Bank in Boston.

Russ holds a JD from Boston College Law School, an MBA from Columbia Business School, and is a holder of the CFA designation. He is also a frequent contributor to the Wall Street Journal, New York Times, Associated Press, as well as CNBC and Bloomberg Television. In 2008,  Russ published “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.

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