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Sheep are timid, nervous, and easily frightened animals. For similar reasons, some fixed-income investors are described as sheepish. Investing sheep get anxious about stock market volatility and are worried when economic, financial, and geopolitical risks increase. With high stock valuations and bond yields respectable, it is time to discard TINA and listen to the bond sheep crying BAAA.
The popular Wall Street acronym of the last decade was there is no alternative (TINA). It implied there was no alternative to holding stocks since bond yields were so low. Before this year, the limited upside in bond prices and meager yields made it tough to argue against TINA.
The bond market sheep are speaking up and saying BAAA. With U.S. Treasury yields around 4% and corporate bonds yields even higher, we should consider bonds are an alternative (BAAA).
To appreciate BAAA, I share the expected returns of stocks and bonds. The analysis will help you decide if the bond sheep are on to something.
Expected returns
Computing expected returns for bonds is simple; look at the yield. If a 10-year bond yields 4%, then barring a default, an investor will earn 4% annually for 10 years.
Future stock returns are unknown. However, we can use valuation ratios and statistics to establish a range of expected results. Trading on valuations is difficult because, over short periods, there is no correlation between valuations and returns. But, over more extended periods, valuations are excellent barometers of future returns.
For instance, the graph below from John Hussman (2014) highlights how well eight different valuation ratios predicted returns for the subsequent 10-year periods. The difficulty in distinguishing the actual 10 returns in the graph ;for their predictions tells you how meaningful valuations are as predictors of long-term returns.
Given the strong correlation between valuations and long-term stock returns, I share a few graphs to help form expectations on what the next 10 years may hold for stocks. This allows us to compare them to Treasury and investment-grade corporate bond alternatives.
Valuations and returns
The following scatter plots compare three valuation ratios and the subsequent 10-year total return (dividends included) for the S&P 500. The data points represent each quarter's valuation and subsequent return. The circle highlights where the valuation is today. The intersection of the circle and trend line marks the 10-year annualized return expectation. The valuation ratio (x-axis) is not the actual ratio but the ratio measured in standard deviation from the average. This method helps better compare the three valuations.
As shown below, the three valuation ratios provide an expected range of +5% to -2.5% annualized total returns.
Stock expectations versus bond yields
Before comparing expected stock returns and bond yields, it's worth contemplating that a stock investor should demand a return premium versus bond yields. The premium accounts for taking on more price and return volatility and additional risks. Since 1950, investors have earned, on average, a 5.53% total return premium for owning stocks over bonds.
As I share below, an investor can buy a 10-year U.S. Treasury note at 3.95%, which is better than the average of the three expected stock returns. Further, an investor can take some credit risk and earn nearly 6% on investment-grade corporate bonds. Doing so would easily beat expectations for stock returns.
Expected stock returns are on par with risk-free Treasury yields but woefully below the premium spread investors should demand. For the next 10 years, bonds are the better bet.
Pervalle says BAAA
To gain further evidence for our theory, I share a graph from Teddy Vallee, founder of Pervalle Global. His chart below compares the return of the price ratio of the S&P 500 (SPY) to 20-year UST Bonds (TLT) versus the average of the S&P 500 dividend yield and earnings yield less the 30-year U.S. Treasury yield. If the strong correlation holds, bonds (TLT) may significantly outperform stocks (SPY) over the next two years.
Per Teddy Vallee:
The regression implies a negative return for stocks relative to bonds two years out.
Cycles say BAAA
To further back up my relative return expectations, I present another graph. The chart below plots the running 10-year excess returns of stocks versus bonds. To calculate the excess return, I compared the prior 10-year stock total return and the prevailing 10-year UST yield at the start of the 10-year period.
Excess returns are cyclical. Periods of solid excess returns are often followed by periods with lower or negative excess returns. In November 2021, the 10-year excess return peaked at 14.21%, the second-highest level in over 110 years. The odds are future excess returns will pale in comparison.
Summary
Bond sheep have a voice for the first time in a long time. The cry of BAAA is more tempting than the worn-out battle cry of TINA!
Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Stock expectations versus bond yields
Expected stock returns are on par with risk-free Treasury yields but woefully below the premium spread investors should demand. For the next 10 years, bonds are the better bet.
Excess returns are cyclical. Periods of solid excess returns are often followed by periods with lower or negative excess returns. In November 2021, the 10-year excess return peaked at 14.21%, the second-highest level in over 110 years. The odds are future excess returns will pale in comparison.
