April 21, 2009
As the economist Herb Stein famously said, “if something can’t go on forever, it won’t.” Such is the case with Treasury bond performance. The yield to maturity on 20-year Treasury bonds is now approximately 3.30% and 30-year bonds yield 3.75%. The market’s forecast for the future is vastly different from what it has been the last 40 years.
If Treasury yields remain at today’s levels, we are past the peak in their trailing 40-year performance. More likely, government deficits and inflation will force yields up, making the future even bleaker for Treasury bond performance. There is little to no chance of a significant rally from today’s depressed yields. This is a classic case of past returns’ inadequacy for predicting future results.
In baseball, position players are expected to out-hit pitchers, as has historically been the case. The idea of Treasury bond yields surpassing equity yields is like pitchers suddenly hitting spectacularly above historical norms, to the extent that their cumulative batting averages nudged above those of position players. A long-term bet on Treasury bonds (relative to equities) is about as wise as wagering that major league pitchers will collectively bat .300 over the next several decades.
But a bet on other fixed income sectors would make more sense. Corporate and municipal bonds now trade at historically wide spreads and arguably have the potential to deliver equity-like returns.
Timing is everything
Vitaliy Katsenelson, John Mauldin and others have argued that long-term equity performance depends largely on one’s starting point in time – specifically, on “normalized” price-to-earnings (P/E) ratios.
Normalized P/E ratios were originally introduced by Graham and Dodd in the 1930s, and were subsequently analyzed by the Yale economist Robert Shiller. Rather than using current earnings as the denominator in the P/E ratio, normalized P/E ratios use an average of prior years’ earnings. Shiller’s work shows that a 10-year average, which smoothes earnings over the course of a full business cycle, has the greatest predictive value.
Arnott's data provides a convenient way to illustrate the predictive value of normalized P/E ratios. The chart below plots 40-year equity performance against the 10-year normalized P/E ratio at the beginning of the investment (i.e., the P/E ratios are lagged by 40 years so, for example, the 40-year performance as of January 2008 corresponds to the P/E ratio as of January 1968.)
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