Stock Returns

• Stock prices vary greatly with the economic cycle. If you'd bought a broad market index such as the Standard and Poor's 500 (the S&P 500)--the index comprised of the 500 largest U.S. stocks--at the height of the 2000 market and held it for the long haul, it would have taken you seven years to break even; if you'd bought during the 2002-2003 market lows, you would have doubled your money in five years.
  
  

Government Bond Returns

• Bond prices move in the opposite direction to interest rates: When interest rates go up, bond prices go down, and vice versa. During a period of falling interest rates, government bonds can post solid double-digit annual returns; during a period of rising interest rates, government bonds can post negative returns for years.
  
  

Estimating Bond Returns

• Bond returns are comprised of the current yield and changes in bond prices. Every bond is issued with a stated interest that is set until maturity. Bond prices fluctuate in the secondary market and can be more or less than the face value--the contractual amount to be repaid at maturity. The yield is calculated by dividing the amount of annual interest by the current bond price. If you know how much you paid for a bond and when it matures, you know how much interest you will get annually and how much you will get at maturity. For example, if you buy a 5 percent 20-year government bond for $950, you will get 5.26 percent on your money annually (the yield) and $1,000 back at maturity--a 5 percent capital gain.
  
  

Stock Earnings Yield

• Most investors are familiar with the price-to-earnings ratio (P/E), which is calculated by dividing the current stock price by the trailing 12 months' earnings per share. These figures are now available for both individual stocks and stock market indexes such as the S&P 500. The P/E helps you measure how expensive a stock is by looking at how much you are paying for $1 of earnings. For example, a $20 stock with $1 in annual earnings has a P/E of 20. But if you divide the earnings per share by the current stock price, you get the earnings yield--how much a company earns on the invested capital, in this example, 5 percent.
  
  

Comparing Stock Earnings and Bond Interest Yields

• If the U.S. government bond yields 5.26 percent and the current earnings yield on the S&P 500 stocks is 5 percent, the current returns on common stocks and government bonds are comparable. Similar yields can tell you little about future performance, but if they diverge, it may be an indicator of future returns.
  
  For example, if the current government bond yield is 5.26 percent and the current stock earnings yield is 1.23 percent, this suggests that stocks are overvalued and government bonds may be a better current investment. If the government bond yield is only 2 percent and the stock earnings yield is 5 percent, stocks may be a better investment going forward.