Stocks vs. Bonds: The Next Decade

by: Toro August 22, 2008    

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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 the past 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%.

Margins 08 08

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.

NPE:10Y 08 08


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.

Stocks are the best house in a bad neighborhood, given that almost every other asset class is even more overvalued than stocks. 

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

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This article has 13 comments:

  •  
    Aug 22 05:04 PM
    Commodities will outperform stocks, bonds, and real estate over the next decade.
    Reply | Link to Comment
  •  
    Aug 22 08:47 PM
    Nice article, Toro. It's always helpful to run a comparison like this in deciding where to overweight.
    Reply | Link to Comment
  •  
    Aug 23 09:58 AM
    The flaw in this comparison is pretty obvious: Bonds are in a short term bubble making them extremely expensive relative to stocks right now. In 6 months or a year, bond yields are headed up and prices down, making them a pretty decent investment for the regular contributor to an IRA or 401K. On the other hand, in absolute terms, stocks are still expensive, with a ten year trailing PE way above the historic mean. The S&P will have to decline roughly another 25% to put stocks at the historic mean of 16 PE. Until that happens, the projected rate of return on equities seems below that of bonds. Going forward, on a risk adjusted return basis, bonds seem the better deal by a considerable margin.
    Reply | Link to Comment
  •  
    Aug 23 11:12 AM
    are dividends considered in this?
    Reply | Link to Comment
  •  
    Aug 23 04:16 PM
    You summed it up nicely - it's a low-return world. True. Your own words tell you what to do but you aren't listening: stocks are expensive relative to earnings but cheap relative to bonds. You are approaching this as an equity investor and ending up a bit confused: are stocks cheap, or expensive? In fact, stocks are expensive and Treasury paper much moreso. The conclusion you can't seem to reach should be staring you in the face: short the paper!

    From a pure equities standpoint, yes, "the market" is expensive. Still, there are plenty of equities out there with earnings yields a lot higher than 6%. Many have dividend yields higher than that. Find a few of those with good businesses and strong balance sheets and ride them through the recession. Keep a hefty chunk of cash (by which I mean gold) lying around for deployment after stocks and bonds finally blow off - investors who bought 30-year Treasury bonds in 1981 have earned a 15% return every year since then on guaranteed instruments with almost limitless liquidity, and will continue doing so for 3 more years - and definitely get short paper, especially Treasuries at today's prices. Even expensive stocks have some upside potential if their businesses deliver the results an exuberant market is hoping for, but there is no upside to buying an expensive bond.

    My current allocation: 87% cash, -55% 5-30yr Treasuries, 27% precious metals, 33% common equity, 7% preferred equity. I'm prepared for and willing to hold onto these positions even if the market moves against me (as it has for much of the last 4 weeks). If you have a similar tolerance for adversity, this is a great allocation. You will be well-positioned to take advantage of the dramatic corrections we will experience over the next 2-5 years.
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  •  
    Aug 23 07:27 PM
    Excellent article...
    Reply | Link to Comment
  •  
    Aug 23 08:35 PM
    bearfund you are one sharp thinker, you're right, the conclusion (short treasuries) is seemingly obvious. Problem is, the premise (that bonds are overvalued) could be wrong - a lot of credible bears (Shedlock in particular) make a convincing argument for deflation as a result of the credit contraction, and hence interest rates that are lower and lower still a la Japan.
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  •  
    Aug 24 03:16 PM
    I don't believe that we will see anytime soon the 1981 returns on T bonds. Too much cash in the market, too many future retirees eager to put some money into safety. As soon as a deemed safe asset drops in price everybody rushes in; look at the rush on Liberty gold coins the past month.
    Reply | Link to Comment
  •  
    Aug 24 06:36 PM
    This post is just insane, this guy can not foresee what is for dinner and he is telling us that earnings will rise? No one knows what will happen

    But, it seems likely 2008 earnings will collapse in the US market when Obama levies the new taxes on everyone in 2008! Bonds will likely do better for a while, then decline in price as they flood us with liquidity and inflation to pay for the bail out of the GSE.

    We know that there will be fabulous financial stunts as 90 to 100 banks are closed, and the entitlements shoot in orbit with a Democrat Congress. The US is facing one hell of a wrenching decade and no one can foresee anything right now. Stay loose is the watch word
    Reply | Link to Comment
  •  
    Aug 24 07:52 PM
    The above post make me nervous about being short the market, all the bearish sentiment sounds like rumblings of a bull market.
    Reply | Link to Comment
  •  
    Aug 24 09:36 PM
    Of couse stocks will outperform bonds. Since 1999 my personal portfolio has risen more thn fold despite the market being even.Great returns on Mo and BRK have helped that.This year alone my profits on BNI BUD and WMT have been great. Those of us who know real value will always do well and find the "bull market"
    Reply | Link to Comment
  •  
    Aug 25 12:49 AM
    Things look pretty bad for your run of the mill mutual fund. Sure there are bargains to be found in equities and bonds but the risk-reward ratios are poor for both classes. Real estate? Maybe after another 25%. Maybe. Gold? Commodities? Swiss Francs? For diversification maybe, not preservation. I'm putting my chips on Brazil.
    Reply | Link to Comment
  •  
    Aug 25 02:51 PM
    free markets are dying, now is about intervention, in the US, BRICS, everywhere, can you predict these sort of things? this is what is expected to define bonds and stock performance. For sure import taxation will be in, same as job protection. The dollar needs a "healthy correction" to pay old and new debts, M2 and M3 monetary expansion will define performance. If we return to normal times (12% interest rates) is hard to see bonds aoutperforming, but maybe some US corporations overseas can make it. Swiss franc looks not so bad in this perspective, the problem is they cant be too strong against the euro to avoid workers "invasion". So natural resources will outperform IMO.
    Reply | Link to Comment
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