On July 8, the dividend yield on the S&P 500 was higher than the yield on the 30-year U.S Treasury bond for the first time since March of 2009 and this, of course, makes no logical sense at all. It is, however, a very positive sign for future U.S. equity market returns.
On that day – last Friday – the yield on the 30-year Treasury bond fell to 2.10 per cent, below the 2.14-per-cent dividend on the S&P 500. The first reason this is illogical is that it means investors were willing to lock in a smaller income stream in the bond, instead of the higher indicated yield in equities.
More importantly, since 1926 the S&P has never had a 30-year period where the average annual returns fell below 8 per cent, and that includes the Great Depression. Investors buying 30-year bonds in the current environment are not only locking in low income for 30 years, they are forsaking average annual equity returns that are far higher – likely not below 8 per cent – for the same period.
The relative yields on long term bonds and equities have had major implications for future equity performance over the past 15 years, as the accompanying chart highlights.
The grey line on the chart shows the difference between the U.S. 30-year bond yield and the S&P 500 (that is, the bond yield minus the trailing dividend yield on the S&P 500). The orange line shows the cumulative performance of the U.S. equity market in the two years following each result.
For example, the first data point on the grey line shows that in July of 2001, the Treasury bond yield was 4.2-per-cent higher than the S&P 500. The first data point on the orange line shows that in the 24 months after July 31, 1991 (July, 1991 to July, 1993), the S&P 500 experienced an 18.2 per cent decline.
The lines clearly move in opposite directions. As the bond yield rises relative to equity yields, future equity market returns decline. When, like now, the bond yield falls closer to equity yields, history shows that investors can be optimistic about overall equity market returns.
The last reading for forward two-year returns for the S&P 500 was 7.1 per cent (3.5 per cent per year) for the period of June, 2014, to June, 2016. If previous market patterns persist, this number should move significantly higher in the coming months as the orange line moves away from the falling grey line.
Market conditions are, of course, different from 2001. Most importantly, an aging developed world population has little stomach for equity risk, and many investors will park assets in safer bonds regardless of how low the yields go. But even so, for investors with even medium-term time horizons, the relative merits of equities are increasingly attractive relative to long-term bonds.
Follow Scott Barlow on Twitter @SBarlow_ROB.