Will Bond bring down the bull?

Over the ultra long haul, stocks have outperformed bonds by a comfortable margin – and in every country. But since 1980 bonds have practically matched stocks, in the greatest bond bull market of all time. But there are good reasons why investors should demand and receive higher returns from stocks than bonds. As bond yields rise from ultra low levels, does this mean lofty stock market multiples are in peril as well?

Price inflation is peeling itself off the floor…commodity prices have been rising again…US president-elect Donald Trump has a big, shiny stimulus package planned, in the form of tax cuts and infrastructure spending…and the US Federal Reserve has finally had the guts to make a tiny increase in the federal funds rate (but it’s still ultra low).

Rates need to rise to make sure inflation doesn’t get out of hand. Bond yields need to rise to make sure bond investors can still make a real (after-inflation) return.

Shortly after Trump was elected, I wrote about how what his plans could mean for the US corporations and the stock market (see here). What he has in mind is probably good for corporate net profits, but it’s not all one way traffic. Specifically I wrote Valuation multiples could fall as stock investors demand higher future returns due to higher inflation and bond yields”.

If I’m right that would mean lower P/Es and other measures of stock valuation, all other things being equal. But recently I received a challenge to this view from a reader, including the idea that stock investors should expect higher returns than bond investors.

Let’s say stocks have a P/E of 20, a 3% dividend yield and earnings-per-share (EPS) grow by 4% a year. If the P/E stays the same then the return to stock investors will be 7%, adding together the dividends and capital gains.

Now let’s say stock investors decide they want to price stocks for a 9% return, up 2 percentage points. EPS growth will still be 4% a year, so they’ll need 5% dividend yield to get to the 9% total return. The actual amount of dividend dollars paid is unchanged. So for the yield to rise the stock price has to fall.

In this case the P/E – and hence stock prices – would have to fall 40%, from 20 to 12. In this example, a 22% increase in the required return (2% divided by 7%) leads to a 40% fall in stock prices.

My focus today is on why stock investors should both demand and expect higher returns than bond investors. Hence, why rising bond yields could hit stock prices.

Let’s start with the fundamentals. If a company goes bust its assets will be sold off to pay creditors. Shareholders are the last in line, and may not get anything. Except in a few special cases, bondholders will be paid first. In other words, stocks carry a higher financial risk than bonds.

To make up for this higher risk, it’s sensible that shareholders have the prospect of higher returns dangled in front of them. Otherwise they would just sit on safer bonds, or even cash.

This extra return above government bond yields is known as the “equity risk premium”. Historically, since 1900, it’s worked out at 4.4% a year in the US, and it’s a similar story elsewhere in the world. (Note: At that compound rate, and over 30 years, the result is 3.6 times as much money.)

Stock prices also move around more than bond prices in the short term. They’re more volatile. Most institutional investors, and all short term investors, see this as risk, for which they expect a higher reward. (For more on why price volatility is actually a gift from the market to long-term, private investors – and how to profit from it – see here and here.)

But let’s assume for a minute that stocks and bonds are the same risk, and that investors in both deserve and expect the same return. What would it actually take for that to happen?

One way it’s possible is if bond yields keep heading lower, eventually into negative territory, and then becoming ever more deeply negative over years and decades. The bubble would become even bigger and more ludicrous.

Paying to lend to the government? No thanks. It’s bad enough already.

Failing that highly improbable outcome, stocks would have to behave in weird and depressing ways for them to match bonds. Let me explain.

Right now a 10 year US treasury bond yields 2.6%. If you buy it today and hold until maturity you are guaranteed to make 2.6% a year (assuming the government pays you back, which it will because it can always print money).

Now let’s assume stock investors would also accept a return of 2.6%. If the dividend yield is 2%, which is the current yield on the S&P 500, then stock investors would only need 0.6% a year extra return from capital gains.

The P/E wouldn’t change because we’re assuming the market has accurately priced stocks for a 2.6% return. All the capital gains would come from EPS growth. Meaning just 0.6% a year forever. Which is to say sub-inflation. And only one eighth of the long run average EPS growth of 4.8% a year since 1900.

That’s a depressing prospect for US and global commerce, let alone investors. Imagine a world where companies can only grown earnings at 0.6% a year.

Alternatively the P/E could be set much higher. Let’s say it doubles, which would be about 50 in the US (tech bubble anyone?).

A doubling of the P/E would mean a halving of the dividend yield, to 1% (same amount of cash paid out, but on stocks with twice the price). Now investors would need 1.6% a year EPS growth to bring them up to 2.6% a year total profit. That’s still depressing, and still only a third as much as the long run, historical average.

Or there’s another way to look at it. Let’s say EPS does grow at a believable pace. Say 3% a year (still low). Let’s see what that means.

Dividend yield is still 2%. Check. Total required return for the stock/bond agnostic investors is still 2.6%. Check. EPS growth is 3%, meaning capital gains are 3% at constant P/E, meaning total return is 5%. Oops.

To get back to 2.6% required return, with the more realistic EPS growth rate, P/E would have to fall. In fact it would have to fall by 2.3% in the first year, and at an ever accelerating rate over time. This is because the dividend yield would grow over time, with growing EPS and a falling P/E.

By year 10 the P/E would have fallen from 20 to 14.9 and dividend yield would be 3.4%. And the rate at which the P/E would have increased to 3.7% a year.

Clearly this scenario would be absurd. A world where P/E ratios trended to nothing over time, so that stock investors made the same returns as bond investors. Not to mention that after P/Es hit the zero bound – when all stocks would be priced at zero – investors would have to keep pumping in more money just to stay invested. Otherwise you couldn’t keep the dividend yield on previous and new capital down to 2.6%! How ridiculous would that be…

In short there are good reasons why stock investors should want higher returns than bond investors, because stocks are riskier at both the company balance sheet and market price uncertainty levels. The alternative is either truly bizarre or downright depressing.

Of course what stock investors should get, which is 4-5% above treasury yields, isn’t necessarily what they actually get. If you buy too high then prepare to be disappointed.

But as bond yields rise, stock market investors should also want a bigger return. All other things being equal, this means a lower P/E and lower stock prices.

In other words, if the bond bubble keeps bursting and yields (and inflation) keep rising, owners of already pricey stocks should beware. They could be in for a shock. Mr. Bond could sink the stock market.

Stay tuned OfWealthers,

Rob Marstrand


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