T-bill yields are hovering just above their all-time lows as you may have heard. The heavily watched 10-year note offers a measly 1.6% yield these days, while the average yield on all dividend-paying stocks on the S&P 500 is about 2.75% according to my source.
The ~115 basis point differential may not seem like much, but these things add up over the course of 10 years. Let's pretend I buy equal stakes in all the dividend-paying S&P 500 (SPY) stocks with $100,000, and for simplicity's sake it's also year 2000 again. My friend Dan bought a 10-year note with today's interest rates.
10 years later, I log into my brokerage account and see that every company I bought stayed the same. I pocket a gain of $31,165 and meet up with Dan. As we meet for coffee, he takes out $17,203.
Not bad Dan, but I nearly doubled your gains despite a 10-year stagnation in the US economy. If that wasn't bad enough, we didn't even factor the effects of inflation.
(click to enlarge)
Inflationdata.com has done most of the work for us, but let's weigh the 2010-2011 inflation bar into the 2000-2009 inflation bar.
(.9)(2.56) + (.1)(1.83) = 2.487
We can basically assume that 2.5% inflation is the average since 2000. We'll also assume that the Fed sticks to its word, and keeps interest rates tame for the foreseeable future. (so assume 2.5% inflation from 2011-2020 later one).
If you couldn't tell by now, Dan lost some of his wealth. If you factor in the fact that inflation outpaces the yield on his treasury bill by 90 basis points, you'll calculate that he lost $8,644. That coffee has become 28% more expensive since our last meeting along with everything else on the menu, so there's no possible way that Dan's $17,203 from interest can be considered a positive gain.
Again, we are going to trust the fed to prevent major disruptions in the inflation rate, so let's assume 2% average inflation between 2012-2020 in a strong-dollar scenario. Let's also consider a weaker-dollar scenario, where inflation hits 3% on average. We are enclosing a 100 basis point gap between our strong and weak dollar scenarios, which is sufficient to draw a few basic conclusions later on.
Since we're focusing on yields, I'm going to buy equal stakes ($20,000 each) in the 5 top Dogs of the Dow (the highest-dividend stocks in the Dow Jones Industrial Average). Right now, this include the two telecom giants AT&T (T) and Verizon (VZ), which yield 5.1% and 4.7%, respectively. Next are the three healthcare giants Merck (MRK), Pfizer (PFE) and Johnson & Johnson (JNJ) yielding 4.4%, 4%, and 3.9% respectively. The yield on this portfolio should be 4.42%.
Dan decides to try another $100,000 stake in 10-year bonds (with a 1.6% yield like before), as well as another $100,000 in 30-year bonds (with a significantly better 2.77% yield). Here is a chart of our returns after 10 years, assuming our 2 or 3% rate of inflation.
| Nominal Gains (2% inflation) | "Real" Gain/Loss (2%) | Nominal Gains (3% inflation) | "Real" Gain/Loss (3%) | |
| Dogs of the Dow | $54,112 | $27,012 | $54,112 | $15,143 |
| Dan's 10-year | $17,203 | ($3,929) | $17,203 | ($13,150) |
| Dan's 30-year | $31,421 | $7,972 | $31,421 | ($2,276) |
After comparing real gains versus nominal gains, Dan started allocating more of his money towards the stock market.
There are a number of glaring problems with this model that you may be seeing right now. The most obvious is the assumption of no movement in the Dogs of the Dow stocks. If these companies retained their exact rate of growth throughout the 10 year experiment, the shares would at least float fast enough to keep up with inflation. This means that the nominal gains on the Dogs would be more like $86,308 (or 86%) with the more modest 2% inflation scenario. Real gains would be 54% all the time, since share movement would negate the effects on inflation.
In a "vacuum," this makes perfect sense. A stagnant company that is worth $1 billion today should be worth $2 billion tomorrow if the dollar is halved in value. The problem is that an innumerable number of external factors might affect a stock once it's brought into the financial markets.
Still, the only way that stocks with higher yields than competing bonds can lose is in a deflationary environment. Deflation is deadly to a country's export prospects, it shrinks the economy in both nominal and real terms, and paralyzes activity in the financial markets due to negative yields. The term liquidity trap comes to mind, because no rational individual would buy a bond with a negative nominal yield. In other words, yields have to stand still or reverse direction after dropping to zero.
The short term treasuries (like the 3 and 6-month T-bills) have already hit that rock bottom (zero), and the 10-year is now only 160 basis points away. This all occurs while US stocks extend their already steep declines, causing dividend yields to reach undeniably attractive levels.
Surely there are legitimate threats to the global economy, especially as China joins the misery with its economic slowdown, but as it stands US bond yields seem to be pricing in a second Great Depression of some sort (and maybe a giant meteor that wipes out Europe).
Deflation has officially been assumed on the bond market (see that TIPS yields are mostly negative), which leads me to believe that the 10-year T-bill virtually guarantees a loss in wealth if held to expiration. I'm not even acknowledging the chances of significantly higher inflation, which would completely decimate the value of these long-term treasuries.
The following chart illustrates just how close we have moved to the bottom of the yield universe since the Volcker era:
(click to enlarge)
The intrinsic value of America's $9 trillion of public debt is also affected by the value of our currency, which heavily diminishes incentive for the United States to manually strengthen the greenback. If anything, more quantitative easing, or at least gradual expansion of the money supply, would make more sense.
We can deduce that the unlikelihood of a deflation scenario is more than countered by the more probable scenario of higher inflation (and interest rates). As mentioned before, this would crush the value of the low-yield bonds being issued now with rock-bottom rates. Thus, we can also infer that the notion that T-bills are a perfectly isolated safe-haven lies somewhere between deeply flawed and completely wrong. There is plenty of harm that can be done to a bond portfolio overnight.
Going against conventional saying, I'll argue that the Dogs of the Dow have become safer assets than the likes of the 10 and 30-year T-bill given all the inferences I've made above. The bonds have virtually no room left to rise, and virtually unlimited room to fall.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
