Analyzing relative valuations is always a tricky business because you can argue it either way: one is too cheap, or the other is too expensive. Such is the case with our Chart of the Week, which compares U.S. stocks and bonds. This is done by subtracting the current yield on corporate bonds from the earnings yield of the S&P 500 (estimated earnings divided by the index level). Since mid-May 2023 the earnings yield has been below the bond yield. The last time this happened was in the aftermath of the internet bubble and financial crisis, in 2003 and 2009. What does this mean? The most obvious conclusion is first of all that equities are currently more expensive than bonds. But does that mean that stocks have to become cheaper? Or perhaps that bonds are too cheap and need to become more expensive? Or are both asset classes too cheap, as a look at the past would suggest? After all, there were good returns to be had from both stocks and bonds after 2003 and 2009.
And once again: bonds are back in the game
*1-year forward earnings estimates
** Moody's A-rated companies
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/27/23
We would warn against forming this conclusion because the circumstances were different. In the two previous periods, i.e. 2003 and 2009, U.S. bond yields were still on a long-term downward trend that appears to have come to an end in 2022. The Fed has inflation worries in its bones, and its loose monetary policy is over, at least for the time being. Quantitative easing has turned into quantitative tightening. In addition, public debt in the U.S. is now almost twice as high as in the two previous periods and the budget deficit is likely to exceed the 5% mark again this year and next. The geopolitical weather does not look good either: It doesn’t look like the circle of potential foreign Treasury buyers has widened. In short, there are good reasons to suspect that "higher for longer" really does apply in the interest rate arena. And that high (real) interest rates in this case are not a reflection of positive economic expectations.
This brings us to the second major difference: the character of the cycle. The bursting of the Internet bubble and the financial crisis hit the economy hard. However, the subsequent economic recovery was correspondingly strong. The pattern this time is different. We expect negative growth in the U.S. in the fourth quarter of 2023 and the first quarter of 2024, but only on a small scale, and in view of strong labor markets and well utilized capacity we would not call it a veritable recession. In addition, and mirroring this mini-decline, GDP growth is likely to look anemic thereafter. The consensus expects 0.9 % for 2024 and 1.9% for 2025. And yet equity analysts are, as usual, optimistic about earnings, seeing more than 10% growth next year. And this despite the fact that (again unlike 2003 and 2009) there has been no preceding slump in profits of around a third, but only a year without profit growth.
Based on this chart, one should not bet on a repetition of the returns that could be achieved with equities and bonds by investing in the years 2003 and 2009.But whether the S&P 500, after its correction of almost 8% since the end of July, will initiate a correction of the correction towards the end of the year is again another matter. After all, it would fit the seasonal pattern of the past 30 years, where a year-end rally has given the S&P 500 an average return of 4.7%.
This historical comparison, however, might also be one to be wary about. After all, there have been a few decent crashes as well: -14% in 2018, -23% in 2008 and -8% in 2000. The stock market doesn’t always defy gravity.