Stocks Versus Bonds

The bond market is causing the stock market to rumble. Both 10 and 30-year treasuries are at the highest interest rates they’ve been at in over a decade.

Most investors allocate most of their portfolio to the two largest asset classes in the world; stocks and bonds. Overweighting one over the other for the last fifteen years was a relatively easy decision. You don’t need to be Harry Markowitz to know bonds yielding 2.5% are going to deliver…2.5%.

That decision is much less clear today than it was back then.

The simplest way to compare stocks to bonds is by taking the inverse of the price-to-earnings ratio, which gives you an earnings yield, and measuring it against real interest rates. Based on this simple calculation, stocks look fairly valued, some might even say rich, compared to bonds.

Investors make decisions based on this information, even if they’re not making calculations in a spreadsheet. They might say, “Hey, maybe I should lighten up on my stocks, considering I can get >5% on cash and >4% on bonds.”

The trillion-dollar question is, does this actually matter? Should investors be comparing stocks to bonds in this fashion? The answer is both yes, and no.

No, valuations don’t tell you anything about how stocks will perform over the short term. Stocks were expensive in 1996, 1997, etc. This chart shows you what happened over the next twelve months when stocks were at various levels versus bonds. There is no pattern here. Nothing at all.

Even going out three years, the chart looks the same, and the correlation is identical, .23 for each.

Valuations for publicly traded stocks are not like valuations for small, privately held businesses. Let’s say that you’re in the market for a laundromat with no intent to sell it. You just buy the business for the cash flows it generates.

Assume you find one that is kicking off $100,000 a year in net income. Multiples for laundromats are what they are. I’m making this up; let’s say it’s three times earnings. Alright, so you buy this for $300,000 cash, and assuming no growth, you’ll get paid back in three years, and then you’re off to the races.

But if you had a change of heart and decided you wanted to sell after two years, all else equal, it’s unlikely that somebody is going to come along and give you $700,000 for the same business that sold for $300,000 two years ago.

But this type of thing happens all the time in the stock market because animal spirits are a major factor. There are no greater fools in the laundromat industry. For a laundromat, what you pay is what it’s worth. In the stock market, prices change on a daily basis and are often disconnected from economic reality on the way up and on the way down, especially in the short term.

But over the long term, valuations absolutely matter because the reality is you are actually buying small pieces of a lot of companies.

The tricky part about investing based on valuations is they don’t matter over the short term, and few investors are making decisions today that they’re going to leave alone long enough for valuations to matter. I mean, ask yourself, is your current portfolio going to look the same in ten years as it does today? If so, did you dial back your U.S. large-cap equity exposure?

For the record, I’m not making any statements on whether you should or shouldn’t. I only ask the question to make you stop and think about the decisions you’re making and whether or not valuations enter them, and if they even should.

The bottom line is that valuations absolutely matter over the long term, but they won’t matter for you if the decisions you make are influenced over the short term.