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The effectiveness of quantitative easing (QE) on real economic growth will be debated for years. What seems less controversial is the impact of QE programs on asset prices. When current valuations for US fixed income and equity markets are placed in historical context, it reveals a conundrum for asset allocators – both appear overvalued.
Periods of overvaluation in individual asset classes happen regularly within the course of a market cycle, but it is unusual for both high-quality fixed income and equity markets to exhibit above-average valuations simultaneously. The 10-year Treasury currently yields 2.43%. The cyclically-adjusted earnings yield (Earnings / Price) of the S&P 500 is 3.7%. Each of these levels is well below historical averages and would suggest a low return environment looking forward in equities and bonds, especially if valuations revert to long-term averages.
It is still likely that stocks will outperform bonds over the coming years – even if by an uncomfortably small margin. Under that assumption, could a case be made to reduce exposure to US equities in favor of core fixed income? Yes, and the answer lies in the assessment of risk.
We view risk as primarily determined by the price paid for an investment and the corresponding margin of safety. We are comfortable with risk as long as it is adequately compensated and looks to minimize risk when the margin of safety shrinks. In this case, we have determined the risk in US equities has risen alongside prices and lower expected returns argue for some degree of caution. By comparison, the risks assumed in fixed income – even with the prospect of rising yields – are much lower for an expected return that is within earshot of US equities.
[Side note: The potential impact of rising yields on bond investors has been oversimplified and generally overstated in most mainstream articles, which usually fail to account for more nuanced aspects of the bond markets – namely the roll yield captured in steep yield curves and the potential for the yield curve to flatten.]
It has been interesting to observe the attention paid to the risk in owning bonds the last few years. A June 4th click-bait headline on CNBC.com was titled “Hair-Raising Bond Rout Leads to Possible Capitulation.” Sounds scary. Turns out a “hair raising bond rout” is their description of the 10-year Treasury yield rising from 2.19% to 2.31% over the course of 4 days. That doesn't meet my definition of a rout.
Despite what you might read, the downside scenarios for US equities are significantly greater than that of high-quality bonds. Historically, it isn't even close. The chart below shows the drawdowns for the Barclays US Aggregate Bond Index and the S&P 500 Index since 1976.
The worst period (largest peak to trough drawdown) for bonds ended in early 1980 – when the 10-year Treasury yielded 12.75%. That represented a 13% decline in the index (and a heck of an entry point for bond investors). By comparison, the S&P 500 has experienced 7 separate drawdowns greater than the worst period for bonds over this period, with the last couple bottoming at -45% and -51%.
Now that's hair-raising.
This document represents the opinions of the author as of 6.17.2015 and is subject to change at any time due to market or economic conditions, or other factors.Print