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Stock Investors Lose Bond Foundation for Steep Valuations

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(Bloomberg Gadfly) -- Apologists for high U.S. stock prices just lost their favorite defense.

Ten-year Treasury yields rose above 3 percent on Tuesday for the first time since 2014, and bond investors are hysterical. Chris Verrone, head of technical analysis at Strategas Research Partners, told Bloomberg Television on Monday that breaching 3 percent would ring in “a 35-year trend change in bonds” in which investors in long-term bonds would stop making money.

Let’s take a breath. For one thing, no one knows where interest rates are headed. Moreover, bond investors need not fear rising rates. Yes, bond prices decline when interest rates rise, but higher rates also mean higher yields on new bonds. Over time, those higher yields should more than offset lower prices.

Consider that 10-year Treasury yields rose to 15.3 percent in September 1981 from 2.8 percent in April 1953, the earliest month for which yields are available. Even so, those three decades were far from disastrous for bond investors. Long-term government bonds returned 2 percent annually during the period, and the average rolling 10-year annual return was 2.7 percent. That’s roughly half their long-term return of 5.5 percent a year since 1926.

Investors who held shorter-term bonds fared far better. Five-year Treasury notes returned 4.1 percent a year, and their average 10-year annual return was 4.6 percent. That’s modestly lower than their long-term return of 5.1 percent a year since 1926. And one-month Treasury bills returned 4.8 percent with an average 10-year return of 4.5 percent, which is better than their long-term return of 3.3 percent.

No one expects rates to rise as drastically as they did during the three decades leading up to the 1980s. But even if they do, a reasonably diversified bond portfolio is likely to do fine and almost certainly better than it has in recent years.  

Stock investors, on the other hand, should be more worried. It’s widely acknowledged that U.S. stocks are pricey. The earnings yield of the S&P 500 Index is 4.7 percent based on last year’s earnings and 4.1 percent using a seven-year trailing average. That’s an equity risk premium over the 10-year Treasury -- or the expected return from stocks over bonds -- of modestly more than 1 percent.

Bulls are quick to point out that the earnings yield is considerably higher using future earnings. Analysts anticipate that earnings per share for the S&P 500 will grow by 40 percent over the next two years. That translates into an earnings yield of 6.5 percent based on earnings estimates for 2019 and a more flattering equity risk premium of 3.5 percent.  

But those earnings estimates seem fanciful. Earnings have grown by 40 percent or more in just 17 percent of two-year periods since 1873, according to earnings numbers compiled by Yale professor Robert Shiller. And every one of those occasions followed a multiyear earnings decline or a vicious one-year earnings slump. By contrast, S&P 500 earnings were down one year over the last nine, a mere 3.2 percent decline in 2015.

So the equity risk premium is probably closer to 1 percent, which brings us back to those apologists. Defenders of high U.S. stock prices have argued for years that what counts is the equity risk premium, not the earnings yield. With interest rates on the floor, they argue, stock investors can expect the same premium for owning stocks despite higher stock prices.

That argument overlooks some inconvenient details, however. The equity risk premium hasn’t quite measured up in recent years. The S&P 500 paid a premium over long-term government bonds of 4.7 percent a year since 1926, including dividends. Meanwhile, the 10-year Treasury yield has averaged 2.2 percent since 2012 and the S&P 500’s one-year trailing earnings yield has averaged 5.5 percent -- a premium of only 3.3 percent.

That may come as a surprise because stocks delivered an actual premium of 13.5 percent a year from 2012 through March, wildly higher than the equity risk premium of 3.3 percent during the period. But that divergence is unusual. While the equity risk premium has been a poor predictor of future returns, it’s been a fairly good predictor of future premiums.  

And that’s a conundrum for fans of the equity risk premium. Interest rates won’t stay on the ground forever. With the 10-year Treasury yield on the move, either stock prices will have to decline or investors will have to get used to an ever-shrinking premium.

 

-- Mira Rojanasakul assisted with graphics

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

©2018 Bloomberg L.P.

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