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 again.
- 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 invalid.
- 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.
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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 returns.
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 earnings yields.
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 as:
DPV = FV/(d-g)
- DPV is the discounted present value of the future cash flow (FV);
- FV is the nominal value of a cash flow amount in a future period;
- g is the growth rate.
- d 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 on.
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%.