At this point in the market there is much debate as to its direction and in the short term it is anyone’s guess, but looking into the type of landscape that will be present over the next several years (or more) would be a good start. Take the declining yields (rising prices) of the bond market and the low threat of inflation, or even deflation, and it is easy to see how the bond market has gained such attractiveness. Having a fixed number of dollars in the future seems like a good bet when over the past few years stocks have been declining. Looking at the yields of the 10yr treasury over the past century and comparing it to the yield of the stock market you can gain a perspective of the attractiveness of each asset. The rational investor would think that whichever asset class held the greatest return of yield would be bought until it reached equilibrium with the other. With stocks having the ability to be priced higher or lower from the date that they are purchased there is a natural assumption that the yield of the equity market would be higher than that of the fixed income market for the added assumption of risk. Therefore the green line below shows the percentage change that has to be met (required gains or allowable losses) in order for the stock market to yield the same returns as holding a treasury over the same time period.
The below chart compares the behavior of the S&P 500 (right scale) and the allowable change (in %) of the S&P to yield the same amount of money in a 10 year period as owning a treasury (left scale).*
As you can see by the chart for the first half of the century there was very little expectation for the stock market to outperform the 10yr bond yield, pricing in the risk of stocks by allowing the S&P take a loss over the next 10 years to still breakeven to the 10yr of the same period. This was due to the fact that inflation was very low and there were wild swings in the stock market over the time period. Whenever the treasury yield would get within range of the Stock market yields the dividends of the S&P would increase. Stocks were only priced to require a positive return over a 10 year span once, right before the Great Depression. During the early 1930s the market declined so much, driving the yield on the S&P to nearly 14%, so that the S&P could lose 103% of its value by 1941 and still outperform a 10 year treasury held over the same span. This was also the best buying opportunity of the 20th century because surely the market could not sustain that type of ratio to bonds and the chart shows that it turned out to be a great time to buy.
It wasn’t until 1958 that the market broke from an allowable loss to a required gain compared to the 10yr. This was due to the creeping amount of inflation that emerged over the post-war years, breaking down treasury prices and driving up yields. As the years went on the yield on the treasury continued to rise as a result of runaway inflation and interest rate hikes to cool the economy while the S&P yield remained fairly flat. By the early 80s as the chart above shows a stock decline coupled with yields of the 10yr in double digit territory required that the S&P return above 50% growth to keep parity with the 10yr. The stock market delivered.
From the early 80s the S&P experienced one of the greatest runs in history, rising from 300 to a peak above 1,800 in the late 90s without any major interruption. With bonds not being as safe as the first half of the century, having their prices as well as inflation make them a losing bet, but stocks, having the ability to appreciate with inflation saw a massive influx of cash which resulted in the bull run that is seen in the above chart. After the peak in the early 80s the ratio of required return to have the S&P breakeven to the 10yr treasury steadily declined, and in 2008 has dropped below zero for the first time since 1958. There are many similarities between those times, inflation remains low, and bonds are in vogue because of the guaranteed return that they provide. When the allowable change ratio of the S&P went negative in late 2008, early 2009 it was yet another good time to buy, for the short term it seems. The required return quickly increased reaching a peak of 30% in May 2010 before falling back. While the short term moves in the required return ratio shown here are not as good of an indicator as the longer term trends are, the volatility seen as of late makes for a case study all its own.
Looking at the century chart one must question, is the required return of the S&P going to stay in positive double digit territory creating the foundations of another long run bull market as seen in the 80s; or is the ratio going to swing violently into and out of the negative territory creating that same scenario seen in the first half of the century. All that can be certain is if the ratio goes below -100% it is a good time to buy and if it is highly positive for a long number of years it is because of a highly irregular factor, such as inflation, that is going to provide a major shift in the market.
*To create the ratio I took the amount of real money that one would have after holding a 10yr treasury at the given month’s yield and compared it to the real returns of holding the same amount in dollars of the S&P. The difference in the amounts were then added or subtracted to determine the allowable change in the S&P over that same 10yr period. I didn’t factor in the reinvestment of the dividends or coupon payments because the same opportunities would be present for the money received in each scenario and therefore would have a wash effect. For example a 10yr at 2.5% would result in $1,250 in 10 years. If the S&P was only yielding 1.5% then the equal amount of money would only net you $150 in yield over the same time period, meaning that the market would have to return an additional $100 over the initial $1,000 (or 10%) in order to be equal to holding the treasury.
Disclosure: No positions