Stocks and Bonds: Mind the Gap

Last week was the worst Thanksgiving week for stocks since 1932. Treasury bonds, meanwhile, continued their surge to near record highs. Combine the two, and the gap between the earnings yield on the S&P 500 and 10-year bonds is now about as wide as it's been in a half-century:

Sources: Yale University and author's calculations.

This divergence is extraordinary. In the late 1990s, bonds yielded 3% more than stocks. Today, stocks out-yield bonds by 5.5%.

There is a good debate over what these numbers actually mean. History is clear on one thing: The gap between stocks and bonds doesn't offer much clarity on the future performance of either asset. The gap was virtually the same in 1990 as it was in 2000, yet the former was the beginning of one of the best decades for stocks in history, the latter one of the worst.

It does, however, seem to give insight on the relative future performance between stocks and bonds. When the gap was this wide in the mid-1970s, the ensuing years weren't great for stocks, but they were particularly awful for bonds. When the spread went strongly negative in the 1980s, it marked the beginning of a great period for stocks, but a record-breaking one for bonds. As my colleague Matt Koppenheffer recently noted, bonds have actually outperformed stocks over the last 30 years.

The indicator isn't perfect, but it gives logical ammunition to an argument that seems obvious to contrarian investors: Given the current gulf in yields, stocks are highly likely to outperform bonds over the coming years.

That shouldn't be surprising. When someone is willing to buy a 10-year Treasury bond yielding 1.9% while shares of Intel (Nasdaq: INTC  ) or Johnson & Johnson (NYSE: JNJ  ) have dividend yields nearly twice a! s high a nd growing every year, their message is clear: I give up. Volatility has become so terrorizing that investors are willing to leave a tremendous amount of return on the table in order to avoid the ever-growing ups and downs of the stock market. The odds that stocks will return more than bonds over long periods of time when that mentality exists are high -- certainly worth betting on. Few, however, are making that bet. Investors have poured $145 billion into bond funds this year, while pulling $30 billion out of stock funds.

The trade-off between the two assets ultimately comes down to your time frame. How long do you have to invest? If you're near retirement or funding an education, stock volatility may indeed make bonds the better bet. But if you have more than a few years, as most investors do, there is little reason to favor bonds over stocks at current prices. Moreover, plenty of companies -- particularly large, established global names such as Procter & Gamble (NYSE: PG  ) and Apple (Nasdaq: AAPL  ) -- look cheap not only relatively to bonds, but in absolute terms. The volatility that has pushed investors from stocks into bonds has created dislocations, and wherever there's dislocation, there's opportunity -- particularly for those with patience. A recent study by two Columbia University professors put it best: "The turmoil we have seen in the capital markets over the last decade has increased the competitive advantage of a long investment horizon."

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