Comparing Treasury Bond Returns to Expected Stock Returns

third wave finance 3-10-2017

The first requirement needed to compare the long-term return expectation for stocks and Treasury bonds, is a valuation metric that correlates well with actual outcomes.

Choosing An Accurate Valuation Method

An extremely accurate valuation method (and possibly the most accurate) is “Market-Cap-to-Gross-Value-Added(GVA)”, developed by John Hussman, which divides stock-market -capitalization by GVA (GVA is GDP adjusted for foreign investment).  Writer and investment manager Meb Faber has even recently posted an open invitation for anyone to respond with a more accurate valuation method… he’s still waiting.

Meanwhile, the MarketCap/GVA 12-year valuation expectation has had a 93% correlation with actual returns over the following 12-year period because over long stretches of time stock market returns can be calculated as a stream of revenues — this is what gave rise to value investing and some of the most noteworthy investors in history; its accuracy can be seen as the blue line (expected return) closely aligns with the red line (actual return).

hussman funds market cap to gva

Chart source: John Hussman’s weekly market comment on 3/6/2017 entitled The Most Broadly Overvalued Moment in Market History

The current expectation is as follows: if the S&P500 is held from now until 2029 (i.e. 12-years), a return of less than 12% will be received — this is one of the lowest return expectations in history for stocks.  For a closer look at the existing stock market bubble see Stock Market Bubble Valuations.

Comparable Treasury Bond Yields

This is the easiest part.  Simply look up the current bond yield of a comparable 10-year bond (for example, here); or for a more accurate assessment, approximate the 12-year bond yield by creating a weighted average of the 10- & 20-year bond yields:

As of 3/10/2017, the 10-year bond yield is 2.58% per year; the 20-year bond yield is 2.94% per year; and an approximation of the 12-year bond is 2.652% (weighted average of the 10-year and 20-year: 0.8 * 10yr yield + 0.2 * 20yr yield).

Since a U.S. Treasury bond yield of 2.58-2.652%(annual) would give a reasonable comparison — and since Treasury bonds are of a high credit quality (note: U.S. default risks addressed in Is the “Risk-Free” Rate Really Risk-Free?) — one can see that if it is held to maturity, the return would be approximately 31% from now until 2029 (i.e. 12-years).

12-Year Treasury Bonds vs. 12-Year S&P500 Return Expectation

One should now be able to see that U.S. Treasury bonds are set to significantly outperform the S&P500 by the end of the forthcoming 12-year period — likely by approximately 24%, and without the risk associated with stocks.

The chart below details the history of this comparison showing annual over- or under-performance of the S&P500 (again with a 93% correlation to actual subsequent outcomes).  Note that if the blue line is below zero (as it is now) the S&P500 is expected to underperform a 12-year Treasury bond; if the blue line is above zero the S&P500 is expected to outperform a 12-year Treasury bond; & the more positive or negative the annual expectation is, the more significant the respective over- or under-performance is likely to be.

hussman treasuries vs s&p500

Chart source: John Hussman’s weekly market comment on 3/6/2017 entitled The Most Broadly Overvalued Moment in Market History