Stocks and Bonds, Then and Now

In a July 23 piece by Ned Davis Research, NDR notes that as of the end of June, the annual return for bonds over the past 10 years was 6.4 while the annual return for stocks over the past decade was 2.8%, the largest divergence in 68 years.  Since the summer of 1998, even cash returned a few basis points higher than stocks.

Perma-bulls will note that over 20 years, stocks outperformed bonds.  This is true, but I think this is a hollow argument.  Ten years is a long time for most individuals.  There is no reason why investors should settle for poor returns over 10 years.

"But you can't time the market!" the perma-bulls will say.

Bull-doodoo!  You certainly can!   

Future returns are a function of valuation.  When the market is expensive, stocks will do poorly over the next decade or two.  When valuations are low, equities will do very well over the next 10 and 20 years.

This is true of any asset class.

So will stocks do better than bonds over the next decade?

First profit margins have collapsed to a little lower than the long-term average of 6%.

Analysts are expecting earnings per share for the S&P 500 to be $105-$110 next year.  Current sales per share of the S&P 500 is $1000.  In other words, analysts expect profit margins to return to all-time highs, even though profits, capital and large swaths of business in the financial sector has collapsed!

Thus, $105 ain't gonna happen. 

At 6% normalized profit margins, the PE of the market is 23x.  This is expensive on an absolute basis.  However, relative to the yield on the 10 year Treasury bond, stocks are inexpensive.

In fact, stocks are at the cheapest level relative to bonds in two decades.

So will stocks outperform bonds over the next 10 years?  Almost certainly.

Are stocks a screaming buy? 

No.  Outsized returns in stocks occur from low absolute valuations, not relative valuations.

But given that structural changes in the global economy suggest that normalized profit margins are  probably higher than 6%, stocks are even more attractive than bonds.

However, stocks are the best house in a bad neighborhood, given that almost every other asset class is even more over-valued than stocks. 

But for most investments, it is a low-return world.

Comments

[psychodave]

I prefer comparing the E/P to higher quality corporate (nonfinancials) bond yields.

Using a next-twelve-month Operating Earnings of 85, stocks look attractive, relative to higher quality corporate bonds, at S&P 500 around 1215 or lower.

An Op. Earnings Yield of 7% is no historic opportunity.

In 1949 one could buy blue chips paying 10% dividend yield with an annual dividend growth rate of nearly 20%.

[kerry]

I'm just hoping for a rally near term so that I can (further) get out of a decent % of my current equity positions.

I also want to look at what Buffett and Soros did during the 70s.

[The Observer]

Toro: Did you see the report that CalPers is decreasing allocation to stocks and adding to distressed and high yield debt because they've seen something like 8% annual returns in stock vs 17% in debt?

In any case, forget the S&P 500 and long term investing; Let's speculate on the next bubble!

We've seen the bubbles come and go in tech, real estate, levered finance... We are in the midst of corrections in EMs and commodities, including energy and alt. energy.

So what's next? Distressed debt?

[Joe Drake]

"In any case, forget the S&P 500 and long term investing; Let's speculate on the next bubble!"

I'm with you, Observer!