by Russ Koes­terich, Chief Invest­ment Strate­gist, iShares

“Why own stocks in the first place?” Many investors are ask­ing this ques­tion in light of the long-term stag­na­tion in global equity mar­kets, recent mar­ket volatil­ity and the sur­pris­ing out­per­for­mance by bonds in 2011.

This year so far, US large caps are down around 1% and a broad bench­mark of global stocks is down around 10%. At the same time, bonds — as mea­sured by the Bar­clays Cap­i­tal US Aggre­gate Bond Index – are up around 7%.

Despite equi­ties’ poor per­for­mance year-to-date, there is a clear long-term case for hold­ing stocks. The argu­ment largely comes down to val­u­a­tion. As I’ve men­tioned in the past, both US and global equi­ties are trad­ing well below their his­toric aver­ages. In the United States, the S&P 500 is trad­ing at 12.3x trail­ing earn­ings. Going back to 1954, this is in the bot­tom quin­tile, or lower 20%, of val­u­a­tion levels.

More impor­tantly, val­u­a­tions look even cheaper when com­pared to bonds. A com­mon com­par­i­son between stocks and bonds is to look at the earn­ings yield on stocks — mea­sured by the earn­ings of an index divided by the price — ver­sus the yield on a bond index. Given that Trea­sury yields are arguably dis­torted by the Fed’s quan­ti­ta­tive eas­ing pro­gram, let’s look at the yield on an index of invest­ment grade bonds. Today, Moody’s BAA Index has a yield of 5.16%, while the earn­ings yield on the S&P 500 is around 2.5% more. In Sep­tem­ber, this dif­fer­en­tial reached 3.1%, the high­est level since 1958.

It’s rel­a­tively rare that equi­ties yield this much above bonds. Look­ing at data back to 1954, there were only around 60 months when the spread was this large in favor of equi­ties. This also hap­pened in the mid-1950s, late 1974 and1978. In ret­ro­spect, all of these peri­ods rep­re­sented very attrac­tive long-term entry points to buy stocks.

Today, mar­ket con­di­tions are obvi­ously dif­fer­ent. Fis­cal prob­lems in the United States and Europe are prov­ing dif­fi­cult to over­come and are almost cer­tain to crop up again in 2012. Of course, one could argue that stocks are cheap now because of a loss of con­fi­dence in equi­ties (this was the case in the late 1970s). But even after adjust­ing for today’s weak con­sumer con­fi­dence, equi­ties still look extremely cheap rel­a­tive to bonds.

His­tor­i­cally, there has been a tight rela­tion­ship between con­sumer con­fi­dence and the yield spread between equi­ties and bonds. Since 1991, the level of con­sumer con­fi­dence has explained roughly a third of the vari­a­tion in the yield spread. When con­fi­dence is higher, equity val­u­a­tions tend to be higher, push­ing equi­ties’ yield down rel­a­tive to bonds. The oppo­site hap­pens when con­fi­dence is low. At today’s yield spread and con­sumer con­fi­dence lev­els, you would expect large-cap US stocks to be trad­ing at roughly 18x trail­ing earn­ings rather than 12.5.

For these rea­sons, I’m con­tin­u­ing to advo­cate an over­weight to equi­ties, espe­cially for long-term investors con­cerned with main­tain­ing pur­chas­ing power. My pre­ferred way to try to cap­ture this oppor­tu­nity is through a posi­tion in global mega-caps with high div­i­dends (pos­si­ble iShares solu­tions: OEF, IOO, DVY, IDV and HDV).

Call #2: Over­weight Latin America

I already hold an over­weight view of Brazil­ian equi­ties and am closely watch­ing stocks in Chile. Now, as other parts of Latin Amer­ica, includ­ing Mex­ico, are also look­ing attrac­tive I’m advo­cat­ing an over­weight view of Latin Amer­i­can equi­ties in general.

Next year, I expect Latin Amer­ica to post bet­ter rel­a­tive growth than other parts of the world, includ­ing other emerg­ing mar­kets out­side of Asia. In addi­tion, while infla­tion was a seri­ous prob­lem in Latin Amer­ica last year, infla­tion in the region is now decel­er­at­ing. Brazil­ian infla­tion, for instance, is still above the Cen­tral Bank’s tar­get, but it has fallen to 6.6% today from 7.3% in September.

One poten­tial way to access Latin Amer­ica is through the iShares S&P Latin Amer­i­can 40 Index Fund, the ILF.

Source: Bloomberg

Author is long DVY and IOO

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. Emerg­ing mar­kets involve height­ened risks related to the same fac­tors as well as increased volatil­ity and lower trad­ing vol­ume. Secu­ri­ties focus­ing on a sin­gle coun­try and nar­rowly focused invest­ments typ­i­cally exhibit higher volatil­ity. Bonds and bond funds will decrease in value as inter­est rates rise.

Past per­for­mance is not indica­tive of future results.

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