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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 as high and 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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Fool contributor Morgan Housel owns shares of Intel, Johnson & Johnson, and Procter & Gamble. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Intel, Apple, and Johnson & Johnson, and has also bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson, Apple, Procter & Gamble, and Intel. Motley Fool newsletter services have also recommended creating a bull call spread position in Apple and Intel, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 28, 2011, at 6:28 PM, TMFDarwood11 wrote:

    The future performance of bonds is hinged on the interest rate. Let me see; I can purchase a 10 year treasury bill and gamble that the interest rate over that period will remain at about 50% of the mean, or I can purchase stocks which pay dividends. Duh!

    I've concluded that too many people are chasing short term yield, and as soon as the lemmings will change direction, they too will head for the latest, greatest and newest "short term" cliff.

    Chasing yield? Why, most investors wouldn't do that, would they? Duh!

  • Report this Comment On November 28, 2011, at 6:29 PM, TMFDarwood11 wrote:

    Let me also add, that these "investors" are the same ones who have about $70K in retirement savings (age group 55-64).


  • Report this Comment On November 28, 2011, at 8:08 PM, FutureMonkey wrote:

    Any data on how much the pre-selected "Age Portfolio" in 401k or IRA that auto-balances towards more bond focus as you approach target age is influencing this trend. i.e. Fidelity 2015 fund, etc. I don't know if these funds are big enough to move the needle compared to Actively managed funds, Hedge funds, State Pensions, Endowments, etc.

    Seems to me that even for a inactive, timid investor a defensive large-cap dividend focus ETF like Wisdom Tree's would provide enough diversity to modulate volatility and beat most bond funds.


  • Report this Comment On November 28, 2011, at 8:48 PM, Merton123 wrote:

    John Bogle (The founder of Vanguard) did a study between the dividend yield and absolute return of stocks. When the dividend yield was high the absolute return of stocks were high. And vice versa.

  • Report this Comment On November 28, 2011, at 11:34 PM, DividendsBoom wrote:

    Div yield + long-term div growth rate = return

  • Report this Comment On November 29, 2011, at 5:18 AM, Sunny7039 wrote:

    It has also been noted that major corporations are keeping a lot of cash on their balance sheets, and that corporate insider selling has been high.

    (Note that "a lot" and "high" are imprecise. So, even if these reports are "true," they nevertheless should be scrutinized pretty closely.)

    IF true, what might it mean? One possibility is that insiders expect a serious correction over the next 18 to 36 months, after which you will see a whole lot of M&A activity. Another possibility is that insiders do not have a whole lot of faith in their access to cheap capital markets, and don't want to be caught short if borrowing costs should soar.

    I'm just speculating here. But I am reading Roubini and Economonitor pretty closely these days.

  • Report this Comment On November 29, 2011, at 5:21 AM, Sunny7039 wrote:

    Also, I think everyone should have a pretty decent cash cushion, to avoid selling a major asset (home, stock they've held for a long time) at distressed prices.

    Most people say that a decent cash cushion is about 2 years of bare-bones living expenses (necessities only). Plus, everyone has to have an emergency fund too, which is usually much smaller.

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