U.S. large-cap stocks have outperformed U.S. Treasuries to near-record levels over the past decade, providing a prime opportunity for investors to shift from stocks into bonds.Last time I laid out the situation for U.S. bonds relative to stocks last year Based on relative valuations and weak nominal growth prospects. Notably, stock market performance has actually accelerated since then despite falling inflation expectations and consumer confidence, marking a significant departure from the past five years. We are in an extremely dangerous situation right now for stock investors, and I fully expect the S&P 500 to lose at least 50% relative to long-term bonds such as those included in the iShares 20+ Year Treasury Bond ETF (TLT) during the next down cycle.
Even as inflation expectations and stocks still outperform consumer confidence declines
The performance of the S&P 500 relative to long-term U.S. bonds has generally been consistent with inflation expectations, as measured by the yield difference between U.S. Treasuries and inflation-protected Treasury securities. This makes sense because stocks are real assets whose returns grow with inflation, while bonds suffer as yields tend to rise. From 2018 to 2022, the R-squared for these two variables was 0.93, but over the past year, the relationship completely broke down, with stock prices rising and bond prices falling despite falling inflation expectations. Based on this correlation over the past decade, the S&P 500 to TLT ratio should be at least 30% below current levels.
From a longer-term perspective, the performance of stocks relative to bonds is closely tied to consumer confidence. Increased confidence in the economic outlook often means investors are willing to pay more for stocks than for bonds. However, over the past few years, the SPX/UST ratio has continued to rise despite declining consumer confidence. As shown below, the ratio is very high relative to The Conference Board’s Consumer Confidence Index, which is consistent with the SPX/UST ratio being 50% below current levels.
The stock-to-debt ratio also diverges from nominal GDP growth, which has been closely tracked over the past 30 years. With total domestic income currently experiencing a nominal growth rate of only 3.1% and a real growth rate of -0.5%, nominal GDP growth seems set to slow further. There has never been negative real GDI since the 1940s, except in official recessions, and the average growth rate at the start of these recessions was 2.1%. The same goes for The Conference Board’s Index of Leading Economic Indicators, which is at -7.5%, consistent with a recession.
Valuations suggest stocks could underperform bonds by double digits annually over the next decade
The significant gains in stocks relative to bonds have brought the long-term outlook to its most negative levels since the peak of the bubble in 2000, with the S&P 500 trailing long-term Treasuries by 8% per year over the next decade. No matter which valuation metric is used, unless earnings growth is several times higher than historical levels, the S&P 500 will underperform over the long term. The chart below shows the S&P 500’s 10-year implied annual returns based on various valuation metrics and their correlation with past subsequent returns. These range from an annual nominal return of 5.4% based on historical P/E ratios to -1.8% based on a price/EBITDA ratio.
If we take the average of all these valuation metrics, current valuation implies a 10-year total return of around 1.5% per year. Compared to the 10-year UST’s yield to maturity of 4.3%, this is the largest spread in favor of the bond since the 2000 peak. The chart below shows the projected 10-year excess return for the S&P 500 Index’s 10-year UST as well as the historical realized 10-year annual excess return. Thirty years ago, the R-squared for these two variables was 0.92, indicating that the S&P 500 should fall nearly 3% annually over the next decade.
This correlation between valuation and subsequent long-term returns also holds true if we look back in time. The chart below uses the CAPE ratio and the market capitalization to GDP ratio to show the correlation between valuations since 1947 and annual total returns over the following 10 years. The current CAPE ratio is consistent with a 4% annual return, while the so-called Buffett ratio is consistent with a 0% annual return. Taking the average of the two, the S&P 500 is priced at a discount to the 10-year UST by at least 2% per year, with the post-WWII average performance exceeding 5%.
Sustained stock market outperformance requires currency collapse
Return forecasts based on the chart above implicitly assume that future S&P 500 fundamental growth will be roughly in line with past growth rates. However, there are many reasons to believe that nominal GDP and cyclically adjusted earnings growth will be significantly lower in the future due to slower real GDP growth. Since 1947, US real GDP growth has averaged 3.1% per year, slowing to 1.7% since its peak before the global financial crisis. As I said in ‘Long-term U.S. real GDP growth of 1% is the best-case scenario‘.
If fundamentals grow at 1% in real terms over the next decade, and inflation averages 2.3%, as indicated by the 10-year breakeven inflation forecast, then the S&P 500 should rise 3.3% annually. Adding in a 1.5% dividend yield, the stock should return 4.8% annually, assuming valuations remain at their current extreme levels. This seems reasonable as it is 0.5% higher than the return on the 10-year UST.
However, if investors require equity risk premiums of 5% above the post-war average, we could see dividend yields rise by 4.5% to 6%, which would lift the total return outlook to 9.3%, reflecting a 10-year The sum of the UST return and the 5% equity risk premium. This would require a 75% decline in valuations, which if it happened gradually over the next decade would result in negative annual returns of around -9%, resulting in a more than 13% underperformance relative to U.S. Treasuries.
Soaring inflation is the main risk, which is why I prefer TIPS
Another possibility is that fundamentals would have to grow at an average annual rate of nearly 7% for sales, earnings and dividends to grow sufficiently to maintain current valuations and allow stocks to outperform bonds. The most likely way this will happen is if inflation continues to rise.However, the problem here, as I explained in ‘Inflation and stocks: the good, the bad and the uglyThe reason for this is that high inflation has a tendency to depress stock valuations. Therefore, we may need to see a significant currency depreciation in order for nominal earnings and dividends to rise, and for stock valuations to fall. It is for this reason that I more Like holding Treasury Inflation-Protected Securities, which provide protection against spikes in inflation.