Monday, April 13, 2015

The Relationship Between Stocks and Bonds

A Wealth of Common Sense has a recent post 'Stock Market Losses with Low Interest Rates' that outlines:

  • Just because interest rates are low doesn’t mean stocks can’t or won’t fall. Interest rates are a very important factor in the markets but they’re not everything. 
  • Stocks are risky. To make money you have to be willing to accept occasional losses. Get used to it if you’re invested in risky assets. 
  • Even in a volatile market environment laced with bear markets, stocks can still make money for patient investors.
His points are extremely important and investors should be prepared for this volatility, but there is a relationship between stocks and bonds that I've found helpful when making allocation decisions.

Backdrop: The relationship between stock and bond yields hasn't always been strong

Before the 1960's, there was hardly any relationship between stock and bond yields. The late great Peter Bernstein wrote about a period in the 1950's when dividend yields moved lower than treasury rates for the first time, a phenomenon most investors thought was temporary:
When this inversion occurred, my two older partners assured me it was an anomaly. The markets would soon be set to rights, with dividends once again yielding more than bonds. That was the relationship ordained by Heaven, after all, because stocks were riskier than bonds and should have the higher yield. Well, as I always tell this story, I am still waiting for the anomaly to be corrected.
That differential has finally "corrected" on and off since the crisis, but an investor waiting for it would have missed the 10% annualized stock returns since it first flipped in 1957.

Starting at roughly that same time, the relationship between stock and bond yields grew tight, but instead of a connection through dividends (and the corresponding yield), the connection was through earnings. From the early 1960's through the late 1990's, the Fed Model was viewed as the "new normal". Per Wikipedia:
The model is often used as a simple tool to measure attractiveness of equity, and to help allocating funds between equity and bonds. When for example the equity earnings yield is above the government bond yield, investors should shift funds from bonds into equity. 
The 0.83 correlation from 1965 - 1999 between the CAPE yield (earnings yield based on the cyclical adjusted price to earnings ratio) and 10-year treasury rate provided support for this theory. Since 2000, the correlation between the CAPE yield and 10-year treasury rate has become unhinged at -0.64, highlighting a world where stocks have broadly underperformed in periods of declining rates i.e. flight to quality.

The connection between stocks and bonds... valuations have always mattered

Yet... despite the three stock/bond yield regimes outlined above and in the chart below (low correlation, high correlation, negative correlation), valuations have always driven performance. When the relationship was non-existent, with CAPE yields high relative to bond rates, stocks materially outperformed. When the late 1990's stock bubble pushed CAPE to record highs (and CAPE yields to record lows relative to bond yields), stocks underperformed.

Where do we currently stand? 

Ignoring my view on whether the CAPE is artificially high at 27, we have a CAPE yield of 3.7% relative to a sub 2% treasury rate. Based on history, stocks "should" outperform bonds over the next 10 years (over the past 50 years, they've never underperformed bonds over 10 years when yielding more) and have provided a return in the 2-5% range above the yield on bonds (call it 4-7% nominal at today's levels).

So while stocks absolutely can (and will) sell-off despite low rates at some point, low rates do appear supportive of an allocation to stocks "relative" to bonds here in the U.S. and especially abroad.

Source: Shiller