Thanks to all who attended the first of the 2013 Monarch “winter” lunch series on Tuesday. We say “winter” because the thermometer indicated otherwise….60 degrees. At our last “winter” lunch in March, 2012, it was 79. We hereby vow to host a lunch every week! Maybe because of the weather, maybe the free lunch, but it was a standing room only crowd!
Ever since the recession/financial crisis/bear market, we’ve been touting the stark valuation gap between stocks and bonds as a historical anomaly. Said more succinctly, stocks have been waaaay cheaper than bonds ever since the bear market ensued. We judge this by looking, first and foremost, at the earnings yield (inverse of P/E) of the S&P 500 minus the 10-year Treasury bond yield. This is also called the “equity risk premium.” Right now, even as the stock market is approaching the 2007 all-time high, the ERP is higher than it’s ever been, save for the last 1 1/2 years and 1 quarter in 1974. At 5.1%, it’s modestly below the all-time high, reached in the fall of 2011, and way above the long-term average of 0%. It’s also way above the level reached in March, 2009 (the low point of the bear market) of 3.2%. How??? Since the low point for the market, the P/E has actually shrunk; while the market has more than doubled from the low, earnings have actually risen far more, thus the earnings yield has risen. Here’s the chart, one more time:
This is either one of the greatest buying opportunities for stocks of all time, or one of the worst opportunities for bonds of all time, or both. In the short-term, obviously anything can happen. We never thought we’d see bond yields this low. But history always reverts, eventually, so at some point, this gap must close. When it does, either one of the two above statements, or both, will come true.
There are some well-reasoned arguments for why bond yields are still low. Mutual fund investors have shunned stocks as too risky ever since the bear market. Bond fund managers who have reaped well over $1 trillion of new money in the last few years have needed to buy long bonds in order to stay competitive with the guy down the street, because short-maturity bonds don’t pay anything. And the Fed is above all, with its foot stomping on the yield curve.
But that could all change very easily, like when the economy starts to recover in earnest, or when less money is getting hoarded than it is currently. After all, the Fed’s real (totally apolitical) goal of keeping rates low is that both of these happen. When they do, look out above, bond yields.
George highlighted some scary numbers showing what would be the price change on treasury bonds from 2% higher yields. So, the 1.96% yield on a 10-year treasury bond would need to rise to 3.96%. Surely rates couldn’t double, could they? Well, the 10-year was actually trading at that level in April, 2010. Yes, AFTER the financial crisis! In the 2000s, the norm was 4-5%. In the 1990s, it was 5-7%.
Anyway, here’s what would happen to the price of a 90-day t-bill, 5-year t-bond, 10-year bond, and 30-year bond:
| 90 day | -0.5% |
| 5 year | -9% |
| 10 year | -16% |
| 30 year | -29% |
A -29% return on holding a “safe” treasury bond!? Actually, factoring in the initial 3% yield, your total return for the first year would be -26%, not quite as bad. But you would need to own the bond for 10 years, and hope rates don’t keep rising, to see your cumulative total return (for the whole 10 years) rise back above 0%. And that doesn’t factor in inflation.
Lest you think we didn’t talk about Washington, we did show this picture from December’s “fiscal cliff” standoff: