By Gary N. Smith
On August 21, 2017, with the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.05% at 2,428, I wrote a MarketWatch column that pushed back against gloom-and-doom pundits who were predicting an impending market crash.
I argued that such dire warnings completely ignored the significance of low interest rates. At the time, the 10-year Treasury /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -2.50% yielded 2.18%, so that the real, inflation-adjusted rate was near zero, compared to a 3.3% real earnings yield on stocks.
My conclusion was that: “Nobody knows whether stock prices will be higher or lower tomorrow, or next week, or next year. But for value investors who don’t try to predict short-term price fluctuations, stocks are attractively priced relative to bonds.”
The S&P 500 now is 80% higher. So, surely stocks are overpriced. Not so fast. Yes, stock prices are higher, but interest rates are lower, with the 10-year Treasury yield now at around 1.33%.
Let’s do some back-of-the envelope value-investing calculations: With the S&P 500 dividend yield at 1.33% and a 5% dividend growth rate (the long run average), the implied return for U.S. stocks is 6.33%, comfortably above Treasury rates. Add in corporate share buybacks and the market’s return is even higher.
Another way to look at the bond/stock comparison is that the interest rate on 10-year Treasurys and the S&P dividend yield are both around 1.3%. The crucial difference is that bond coupons and maturation values are fixed while stock dividends and prices will surely grow over time.
If the U.S. economy, earnings, dividends, and stock prices are not substantially higher 10 years from now than they are today, we will have a lot more to worry about then our stock portfolios. If they are higher, we will be glad we bought stocks instead of bonds.
A second benchmark model was proposed by Vanguard Group founder John C. Bogle for estimating stock returns over a 10-year horizon. His insight was that stock returns consist of dividends and capital gains and that changes in stock prices can be broken into changes in earnings and changes in the price/earnings (P/E) ratio. If earnings grow by 5% and the P/E increases by 2%, stock prices will increase by (around) 7%.
With the current 1.33% S&P 500 dividend yield and a projected 5% average annual growth in earnings over the next 10 years, the Bogle model implies a 6.33% annual return on stocks if the S&P 500 P/E ratio 10 years from now is still 34, its value today. The annual return on stocks will be 5.07% if the P/E falls to 30 and 3.31% if the P/E falls to 25. We can play around with various assumed earnings growth rates and future P/E values, but most plausible scenarios favor stocks over bonds.
Finally, consider Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE). The cyclically adjusted earnings yield (CAEP), which is the inverse of CAPE, provides a rough estimate of the real, inflation-adjusted return from stocks and should consequently be compared to the real, inflation-adjusted return from bonds.
Shiller’s CAPE is currently around 38, which implies a CAEP of 2.6%. With a 1.33% nominal rate on 10-year Treasurys and a Fed-targeted inflation rate of 2%, the real return on 10-year Treasury bonds is –0.67%, an estimate that is consistent with the current –0.97% real return on 10-year Treasury Inflation-Protected Securities (TIPS). Once again, stocks look good relative to bonds.
The peril, of course, is that an outbreak of inflation will cause a substantial rise in interest rates. An interest rate surge would clobber long-term bonds as well as stocks, and the gloaters would be those who bought short-term Treasurys paying only a smidgen more than cash.
Short-term fluctuations in interest rates are difficult to predict, as are short-term fluctuations in stock prices, but the bond market tells us what investors are predicting for inflation and interest rates over the next 10 years. The difference between the nominal 10-year Treasury rate and the 10-year TIPS rate reflects the market’s anticipated annual rate of inflation over the next 10 years. That difference is currently a benign 2.3% — expectations that are consistent with the Fed’s 2% inflation target.
Interest rates are currently 1.33% on 10-year Treasurys and 1.86% on 30-year Treasurys. Taking into account the normal risk premium on long-term bonds, investors evidently believe that low interest rates will be around for quite a while.
Markets are hardly infallible but it is nonetheless noteworthy that bond prices reflect expectations that inflation and interest rates will remain subdued over at least the next 10 years.
Investors who disagree with that assessment can take out their shovels and start digging. For investors who agree with that assessment, I repeat what I wrote four years ago: Nobody knows whether stock prices will be higher or lower tomorrow, or next week, or next year. But for value investors who don’t try to predict short-term price fluctuations, stocks are attractively priced relative to bonds.
Gary N. Smith is the Fletcher Jones Professor of Economics at Pomona College. He is the author of “The AI Delusion,“(Oxford, 2018), co-author (with Jay Cordes) of “The 9 Pitfalls of Data Science” (Oxford 2019), and author of “The Phantom Pattern Problem” (Oxford 2020).