“Exploring the Stock Market vs. Bond Market dilemma: Unraveling the potential risks and rewards in a world where Treasuries offer a tempting 5% yield.”
The recent increase in the yield on 10-year Treasuries has led many investors to shift from stocks to bonds. The impact of interest rates on stock returns is a topic of debate, but looking at historical data can provide some insights.
Chart 1, which dates back to 1971, shows that buying the S&P 500 when the 10-year Treasury yield is below 4% or above 8% has generally resulted in positive annualized real returns of 8% to 16% over the next ten years. However, buying when the yield is around 5% has historically been the least attractive time.
Chart 2 helps explain this pattern by showing the cyclically adjusted price earnings ratio (CAPE) of the S&P 500. It indicates that CAPEs tend to decline as long-term interest rates rise. High long-term rates can signal high inflation or higher real returns demanded by investors, both of which are unfavorable for stocks.
When the 10-year Treasury yield is in the middle range of 4% to 7% or 8%, CAPEs tend to soar, leading to overpriced stocks and lower future returns. Currently, with a CAPE of about 29 and a 5% yield, stocks may not be the most attractive investment option.
However, it’s important to note that the 5% yield on 10-year Treasuries is a nominal return, not adjusted for inflation. Inflation-protected bonds offer a real yield of about 2.43%. Chart 3 shows that the actual real return on 10-year Treasuries can be lower than the nominal yield, indicating the risk of unexpected inflation.
If you trust historical data, 10-year Treasuries offer similar expected annualized real returns as inflation-indexed government securities. However, if you believe there is a significant chance of a large inflation shock, inflation-indexed securities (TIPS) may be a safer and higher-yielding option. Alternatively, high-quality corporate bonds or mortgage securities backed by the US government can offer higher returns compared to Treasuries.
In conclusion, stocks have more downside risk compared to bonds, but past experience is not a guarantee of future returns. It’s important to consider the current level of Treasury yields and the CAPE ratio when making investment decisions.