It is fair to say that 2013 will be remembered as the year that the rotation out of Fixed Income, notably Treasuries and money markets, into equities began. What started as a tentative rotation in early 2013, out of money market funds into equities, truly got underway since May 2013 following the mention of the word "taper" by the FOMC.
As per chart 1 above, the "taper" comment impacted 30yr Treasury significantly with equities able to maintain their gains to eventually continue rallying once there was some soothing comments by the chairman of the FOMC that "tapering was not tightening". I for one do not buy that argument but semantics for now.
Given that the rotation is now underway, how much more can we expect in 2014? To try and answer this, I looked at quarterly data since 1977 as I believe we need long-term data to try and answer such big secular questions.
To look at the relative valuation basis, I will use the 30yr Treasury as the Fixed Income proxy and will use the S&P 500 Index (SPX) as the equity proxy. I believe that long end Treasury is the better comparison to equities if you tend to view equities as very long stream of cash flows which is very often the assumption under variants of the DCF models.
Yield Basis - 30yr treasury Yield vs Dividend Yield
Chart 2 shows the long-term downtrend in 30yr Treasury following Volcker's aggressive hiking of the policy rate to combat the stagflation crisis in the mid to late 1970s. Since the rate peak in 1981, 30yr Treasury rate has been on long-term downtrend and currently appears to be close to the top of the downtrend channel. Prior to the financial crisis, 30yr Treasury rate was around 4.5% to 5.0%.
From Chart 3 above, currently the spread of 30yr Treasury to dividend yield stands around 1.85% vs the 2.50% back in late 2007/early 2008 prior to the financial crisis. I subjectively tend to use that period as the "normal" period as it was the last good "normal" period before the financial crisis.
However for stocks dividend yield is too restrictive as this is subject to payout ratios which tends to vary across sectors. A broader valuation measure for SPX would be the Earnings Yield or the inverse of the Price to Earnings ratio. For this analysis, I will be using the trailing 12-month earnings.
Yield Basis - 30yr treasury Yield vs SPX Earnings Yield
In Chart 4, in absolute terms earnings yield tracks the 30yr Treasury yield better than the dividend yield from 1977 to 2002. Some theoretical justification for this relationship would be to think of an equity as a long series of cash flows as assumed in the Dividend Growth Model.
We can now look at the difference between earnings yield and bond yield which I call Premia as shown in chart 5.
With the more recent data points given in tabular form below:
The realized earnings growth in 2013 for SPX has been 7.1% and given the rally of roughly 30%, the Earnings Yield compression from 7.0% to 5.8% (or P/E expansion from 14.2 to 17.2) explains the extra 23% increase.
The Premia has compressed from a peak of 5.3% in mid 2011 to the current 1.9%. For 2013, the Premia compression from 4.1% to 1.9% came from 1% rise in 30yr Treasury and 1.2% fall in SPX earnings Yield.
A few observations from Chart 5 and Chart 2:
- A fair bit of premia compression has occurred but not yet back to the 2007 levels of roughly 1.0%.
- SPX earnings yield of 5.8% is already back to 2007 levels.
- From chart 2, 30yr Treasury yield of 3.94% is roughly 1% away from 5.0% level observed in mid 2007.
- Following the Volcker shock to fixed income, Premia remained negative (1981 to 2002) until the Nasdaq bubble when Premia then turned positive. At the risk of simplifying things, it does seem that prior shocks tend to dictate which side of 0, Premia ranges in.
Putting everything together, given persistent sentiment regarding stocks and fixed income, I think a Premia of around 1.0% could be revisited in 2014 which would take us back to around the lows of 2007. This Premia compression of 0.9% of course could come about by a mixture of higher 30yr Treasury and lower SPX earnings yield via higher P/E.
Personally, I am using 4.50% -4.60% as the high in 30yr Treasury for 2014 under the assumption that things go according to plan, that is:
- Inflation given by Core PCE remains in the 1.50%-1.80% range. Anything higher than that would seriously make the market question the FOMC's conviction/ability to keep the federal funds rate low for long as currently priced by the market with the first rate hike happening in 2015.
Somewhat of a philosophical point, I know everyone hates fixed income at the moment but when it comes to Treasury bonds, there is this ultimate safety that no matter what happens you know you will receive your principal back at maturity. I very often asked myself how I would have reacted if I was around 55 years old (close to retirement without a defined benefit pension) going into 2008 with a sizeable portion of retirement funds in stocks.
- What would my reaction have been? Would I have bought when market dropped the first 10% (currently many people seem to be waiting for that to buy on dips)?
- Would I have bought at the 20% mark?
- Finally, would the devastation of principal be too much to bear which would have forced me to get out of stocks altogether at some point in late 2008 - early 2009?
I honestly do not know what I would have done and consider myself lucky that I was not in a position to need to answer these questions. But ultimately holding Treasuries till maturity is one way of not having to answer these questions.
With the well advertised baby boomer generation starting to reach retirement age and with 2008 still "fresh", I often wonder if stocks will be still be viewed as a core holding that close to retirement.
Clearly 3% in 10yr Treasury and 4% in 30yr Treasury is still inadequate for too many of us but I do believe that the argument above can certainly be one reason why rates may not move too high, assuming inflation remains well behaved.
So until 30yr Treasury hits 5.0%, which is what I personally would be happy with (but knowing how the human mind works, if 30yr hits 5.0% I may get greedy and wait for 6.0%), here is how I am shaping my fixed income portfolio.
- Buying high coupons preferred shares with callable features in 2016/2017. These can yield 4-6% to the callable date.
- Buying Municipal bonds, buying Proshares UltraShort 20+ Year Treasury (TBT) and selling upside calls on TBT.
- Buying HY ETFs.
- Buying REITs such as Realty Income Corp (O)
Additional disclosure: I am long NLY.PRC, JPM.PRC, CWHO