I have listened to Wall Street strategists expound for months about how the US stock market is reasonably valued in an environment where yields in the US government bond market continue to decline. The yield on the 10-year Treasury note fell to a record low 1.37% this week. The dividend yield on the S&P 500 index (NYSEARCA:SPY) is currently 2.1%. This makes the stock market look like the obvious winner from a simpleton's standpoint, but for an investor with any cognitive function at all, it is clear that we are not comparing apples to apples. An investment in US government debt carries with it a guarantee that your principal will be returned to you upon maturity. An investment in the stock market does not. The risks could not be more disparate.
In the past, when the yield on the S&P 500 rose in comparison to the yields available in the bond market, it was because stock prices had declined significantly. It presented a value proposition. Today the stock market flirts with all-time highs, as bond yields have plunged to record lows. There is an obvious reason for this plunge in yields. Central banks around the world have reduced the available supply of low-risk and high-quality securities available through their bond-purchase programs, driving yields lower and forcing investors to reach for yield in lower-quality and higher-risk segments of the fixed-income markets. A global yield grab is underway. Some of the funds that would have been invested in fixed-income markets have shifted to the equities markets in search of yield.
There is another far more disconcerting reason for the plunge in yields, which I don't think the bullish camp is fully appreciating. Consider the fact that when the Federal Reserve raised short-term interest rates just six months ago on the assumption that the rate of economic growth in the US was accelerating, the 10-year Treasury was yielding approximately 2.3%. It has fallen nearly a full percentage point since then. I believe this decline is more about the fear of loss and the fear of deflation than it is about reaching for yield. It certainly doesn't imply an accelerating rate of economic growth.
When declining long-term interest rates indicate that the rate of inflation is moderating from higher levels that could slow the rate of economic growth, then it is a form of stimulus, and stock valuations are likely to expand in the expectation of profit growth. Yet the benefits wane as rates continue to decline. If long-term interest rates fall too low, which is where I think we find ourselves today, it indicates deflation, which stifles the rate of economic growth. The reach for yield then becomes an effort to avert loss.
Today's yields don't indicate a moderating rate of inflation that is likely to sustain a modest rate of economic growth. Instead, they indicate global deflation and the high probability that the rate of economic growth in the US and abroad will continue to slow. Why else would investors holding approximately $11 trillion in sovereign debt around the world be willing to accept a guarantee that they receive less than their original investment at some point in the distant future? This is the definition of deflation.
The bullish consensus is deflecting these concerns by assuming that the US is immune to the risk of deflation and the fear of loss that is blanketing the rest of the world. This is naïve thinking in what is a global economy. It may be true that foreign investors are buying US Treasuries, further suppressing yields, because of the comparative yield advantage over their domestic government bond markets. All this means is that we are the caboose on this high-speed train to zero.
I would prefer to hold a 10-year Treasury rather than the S&P 500 index, based on the potential for returns over the next 12-18 months and the commensurate risk profiles of each today. In other words, I think the risk-adjusted returns of a 10-year Treasury yielding 1.37% are more attractive than that of the S&P 500 index.
I am not suggesting that an investor who holds a 10-year Treasury until maturity will outperform an investor who holds the S&P 500 for the next ten years. I would like to think that the S&P 500 will outperform. Still, the forward 10-year returns for the S&P 500 from current valuation levels over the past 30 years have been well below historical averages, and in one instance it was negative. The only point in time at which the median P/E was higher than it is today over the past three decades was on 12/31/2001, and the annualized return for the S&P 500 was below that of what you would earn buying a 10-year Treasury today.
The plunge in bond yields to all-time lows is a warning sign for equity investors. It suggests we will see a continued slowdown in the rate of economic growth, which will stymie corporate revenue and profit growth. I continue to believe that bonds will outperform stocks, as I suggested at the beginning of this year and the year before.
More specifically, I believe that the 10-year Treasury will outperform the S&P 500 over the next 12-18 months. The reasons being that the yield on the 10-year is likely to fall below 1% and that the S&P 500 is likely to suffer a significant decline. When we see a major valuation adjustment for the S&P 500 index, we will also see another investment opportunity with 10-year return potential that approximates historical averages.
Disclosure: I am/we are long TLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.