If you had spent your entire life in the Twilight Zone, and were
just now coming out of it, normal things might seem strange to you.
This is exactly what has started to happen. In a normal world, low
yields on bonds tell you that stocks are risky, and that earnings
yields should be higher to compensate for this. But that is not
what investors from the Twilight zone perceive. They lived and
learned how to invest during the only time in history when yields
on 10 year treasuries consistently exceeded the earnings yield, any
time that this is reversed, they automatically sense trouble even
though this was a perfectly normal condition all of the other 110
years that we have data for.
There is a lot of loose talk about a bond market bubble that is
based on Twilight Zone thinking, but a more extensive study of
historical relationships reveals four important facts that bond
bears may not have noticed:
- Prior to 1970, it was normal for bonds to yield less than
equities. There are perfectly good reasons for them to do so
- There is information embedded in the price of equities about
future returns, but there is no information embedded in the price
of bonds about future returns, so direct comparison is
- The entire notion that equities out-perform bonds over the
long-run is based on a single episode, from about 1950 to about
1970, when inflation accelerated unexpectedly. Other than this
period, bonds competed very effectively with equities for over
110 years, and throughout most of this time, bond yields were
lower than earnings yields.
- There is no sound theoretical basis for expecting a 1:1
relationship between equity yields and bond yields.
click to enlarge images
The real problem with comparative yield analysis is that you are
comparing two things that are not comparable because they don't
have the same predictive powers. Earnings yields have a meaningful
ability to predict future real returns on equities. Although you
have to de-cyclicalize the earnings, adjust for inflation, and live
with the fact that prices move within a very wide band around the
mean, there is nonetheless, a very clear trend established in the
data from over 100 years of monthly prices. The scatter chart below
shows that low price / trend earnings consistently lead to very
high returns, and high price / trend earnings ratios consistently
lead to very low returns. The current ratio of 18x has resulted in
negative real returns in all but a couple of cases.
No such pattern exists with bonds. Real bond yields and real
bond returns have almost zero correlation, and bond yields at the
current level of about 0.8% have led to positive returns over the
subsequent 10 years with about equal frequency as negative
Long Run Returns are Not What You Think
An unspoken part of the background for almost every bearish
argument on bonds is that equities have "always" out-performed
bonds over the very long term. If this is the foundation for any
argument, it does not really stand up to scrutiny. The entire
notion based on a single episode, from about 1950 to about 1970,
when inflation accelerated unexpectedly. Other than this period,
bonds competed very effectively with equities for over 110 years,
and throughout most of this time, bond yields were lower than
None of this discussion so far means that interest rates have no
effect on asset prices. Interest rates are important, but they are
only one thing among many others that influence asset prices. All
valuation models are merely simplified forms of the discounted cash
flow model, which measures of the value of all cash flows that an
asset is likely to generate over its lifetime and discounts them by
an interest rate, known as the risk premium, to get the net present
value. The disadvantage of the DCF model is that there are a lot of
variables in it, and therefore, a lot of opportunities to be wrong.
Simpler valuation models don't eliminate the possibility of being
wrong, but rather, just ignore them. An earnings yield eliminates
growth as a factor. A bond yield eliminates the equity premium as a
factor. Simplifications are useful when the factors being
eliminated are trivial or constant, which was the case in the
Twilight zone, but isn't any longer.
The discounted present value for any asset can be expressed
DPV = FV/(d-g)
is the discounted present value of the future cash flow (
is the nominal value of a cash flow amount in a future
is the growth rate.
is the discount rate, which reflects both the cost of tying up
capital and the risk premium associated with the possibility that
the expected growth rate might not be achieved.
The Fed Model, which compares interest rates to earnings yields,
focuses exclusively on near-term earnings and the risk-free
interest rate, excluding both the rate of future growth in earnings
and the risk premium. The Fed Model works when either of these
factors are constant or when they cancel each other out. In
high-interest rate environments, higher growth tends to be
associated with higher risk, and so these two factors often move in
opposite directions, so indeed, they cancel each other out. Another
thing that happens in a high-interest rate environment is that the
weight of the interest rate, relative to the weight of the growth
rate, increases. The only things you need to know as long as this
environment prevails are the current earnings and the risk free
rate. That is the environment that prevailed for the past 40 years,
so it is what almost any successful investor has used for all of
his or her career.
It is less likely to work as well over the next 40 years. Low
interest rate environments are very different. The lower rates are
caused by significantly lower growth expectations and thus, lower
rates engender a much higher and more volatile risk premium. This
is why you see the earnings yield rising to much higher levels
during low-interest rate environments than it ever does during
high-interest rate environments.
So now that we have lower nominal interest rates than any time
in history, you can count on the risk premium continually going
into spasms of volatility creating wild swings in share prices that
are totally unrelated to either earnings or interest rates. A model
that ignores this is going to be wrong almost all of the time.
So What's the Alternative?
None of the above arguments suggest that either equities or
bonds are necessarily good investments. My models suggest equities
are likely to generate negative real returns over the next decade
in almost any scenario. For bonds, it depends much more on what
happens to inflation. The spread between 10-Year treasuries and
10-Year TIPS suggests that current market expectations are for
inflation to average about 2.4% over the next 10 years. If true,
you can expect to lose about 1.6% annually on your bond
investments, which isn't going to help you retire, but it doesn't
qualify as a bubble either, and it probably beats equities, which
can be expected to lose on average about 3% to 5% annually or more
over the next 10 years. For bonds to significantly under-perform
equities, my projections suggest we will need to see inflation
rates above 5% annually.
To be fair, this is what many bond bears expect, and it's not
implausible. My view is that such scenarios are significantly under
appreciating just how messed up global labor markets remain, but
that is the subject matter for another piece I'm still working
Regardless of which direction markets head, they won't go there
in a straight line. There will be enough volatility that both bonds
and equities will have positive, often significantly positive real
returns during the interim. Because of the increased volatility
that comes with lower rates, Buy & Hold won't anymore, even if
you consider the implication of taxes. I dealt with some of these
timing issues in my previous article,
"How Over-Valued Is Too Over-Valued."
The timing mechanisms I've designed have yet to trigger, and until
they do, my models are still long SPY, TLT, and BND. The SPY trade
was entered 1/31/12 and is up 28%. The TLT trade was entered
1/29/10 and is up 43.7%. The BND was entered after selling IAU on
12/21/12, and is down 2.3%.
I am long [[SPY]], [[TLT]], [[BND]]. I wrote this article myself,
and it expresses my own opinions. I am not receiving compensation
for it. I have no business relationship with any company whose
stock is mentioned in this article.
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