Don’t Exit Stocks as If You’re a Pension Fund

Given the consternation over equity valuations and the lure of rising bond yields, this may seem like a sensible approach, even instructive for retail investors reconsidering their own portfolio allocations. Yet history suggests stocks are necessary for growth even when valuations favor bonds, and furthermore that copying pension fund trading can be a losing strategy for individuals.

It’s misleading to look at high bond yields in isolation since some of the increase in recent years is due to higher anticipated future inflation. What matters is the “real” or inflation-adjusted return that is best measured by the yield on Treasury Inflation-Protected Securities, or TIPS.

The current 10-year TIPS yield is 2.21%. Investing in 10-year Treasuries has historically returned 36% more than the TIPS yield at the time of purchase, measured in annualized real returns over the subsequent 10 years. The premium is because a fixed-rate bond investor takes the risk of inflation differing from expectation, while a TIPS buyer is insulated from that risk. Based on history, buying long-term Treasuries offers an expected 3.01% annualized real yield over the next 10 years, with a standard deviation of 1.02%.

A comparable figure for equities is the inverse of the Cyclically Adjusted Price Earnings (CAPE) ratio. Stocks are selling for 34.41 times earnings, translating to an earnings yield of 1/34.41 or 2.91%. As a first approximation, earnings can be expected to grow with inflation, so this is comparable to the 2.42% TIPS yield. However, historically shareholders have only realized 94% of the earnings yield at the time of purchase because earnings overstate economic reality — or, if you prefer, because corporations do not return the full value of earnings to shareholders. Therefore, if history is a guide, the S&P 500 Index has an expected annualized real return of 2.73% over the next 10 years, with a standard deviation of 4.39%.

Of course, pension fund staff and consultants do far more sophisticated calculations than relying only on current market parameters and long-term historical averages. But the numbers seem to indicate that 10-year Treasuries offer a higher expected 10-year real return than the S&P 500 at a much lower level of risk. It certainly makes greater sense to hold more bonds and less stock today than 10 years ago when the S&P 500’s earnings yield was 4% and TIPS were yielding 0.5%.