Felix Salmon today posted on the huge divergence in yields between stocks and bonds, wondering just how historically unprecedented this divergence was.

Indeed, from 1985 through about 2002, it was just as common for the S&P earnings yield to be lower than the Treasury yield as it was for the yields to be the other way around. The two tracked each other, and the spread between them almost never moved beyond 2 percentage points either way.


In 2002, everything changed. The spread between the two jumped up to a very high level and stayed there, all the way through the onset of the financial crisis. This was the Great Moderation.

And when the Great Moderation imploded, the spread only widened further. Today, it’s about 7 percentage points. At these levels, it’s almost impossible to see how stocks could possibly be a worse long-term investment than bonds. Yes, earnings can fall. But even if they fall in half, stocks will still yield double what bonds do.

What happened? Felix does not know:

I have to admit that I really don’t understand what’s going on in this chart at all. While any given spike can always be attributed to a fearful flight to quality, that doesn’t explain the decade-long trend.

Let’s try to explain because this is important.

First, my data from S&P and the Treasury differ somewhat from that used in Felix’ chart. The difference is in the magnitude of the earnings yield (thus the PE) and probably has to do with whether one uses “as reported” or “operating” earnings. Nonetheless, it does not change the trend that Felix is pointing out. Here is my chart of the earnings yield – Treasury spread:


Second, this rise in the spread is not unprecedented as this chart from 1927 shows:


In fact, Felix’ chart, beginning in 1985, misses the fact that it is the period between 1980 and 2000 that was exceptional. Markets are currently merely returning to normal, if 1927-1980 is normal.

Third, there has been a long 25-year decline in real Treasury yields, from an almost century-high 9.3% in June 1984 to -1.4% currently. As the chart below reveals, negative 10 year yields is not new and current negative real yields are not extraordinary compared with previous periods of negative real yields.


More specifically to Felix Salmon’s question, real yields broke below the 2% level in mid-2002:


This coincided with:

  • the trough in US equities after a 46% collapse over 2 years. Enough to spook many investors.
  • Inflation troughed at 1% in June 2002, down from 3.7% two years before. US inflation quickly bounced back to 3% in February-March 2003 but US Treasuries stayed flat, likely due to investors reaching for safer investments.
  • Real yields were allowed to rise above 2% between September 2006 and August 2007 as US equities kept rising, gaining 90% from their 2002 low. The brutal renewed collapse that ensued might prove to be a generational change of attitude toward equity investing.
  • The Rule of 20 PE ratio (fair PE = 20 minus inflation) also broke down in 2002 (click on chart to enlarge). Whereas it used to move at least partly into overvalued territory in most previous up-cycles, the Rule of 20 PE balked at 20 in December 2009 and at 18.8 in April 2011.


Felix tried his own intuitive explanation:

So with the explicit proviso that I’m not going to try to explain this graph, I’ll tentatively put forward one hypothesis: that the dot-com bust of 2000-2002 had a much bigger effect on stock-market psychology than we might have thought. It made stock investors realize how fragile stocks really are, and concentrate on the risk that they could fall substantially in price. If you think that stocks are going to fall, then it almost doesn’t matter what their earnings yield is — you feel as though you should sell them at any price.

But frankly I don’t really believe it. There’s something more profound going on here; I just can’t put my finger on what it is.

I think Felix is partly right: equity investors have been fried twice within 10 years. Those who also owned a house must be totally numb as we speak and likely would not touch a stock with a 15-foot pole.

However, equity markets have changed a lot in the last 20 years and individual investors, even the traditional pension or mutual funds investors, are now dwarfed by computer trading where algos include no emotional parameters. Hence, as the Rule of 20 chart above and the actual PE chart below show, equity valuation remained well above historical lows.


What Felix did not consider is that it is the fixed income market that has changed significantly as emotional investors seek calmer waters with herd-like instinct. The clear move in real yields below the 2% level and the acceptance of occasional negative real yields since 2002 is a reflection of the substantial increase in the preference for safety on the part of individual and many pension fund investors as a result of their terrible experiences with equity and housing investments since 2000.

Given the fast aging of the population, the huge loss in confidence towards politicians and the alarming rise in sovereign debt levels across the world, it seems safe to assume that this is the new paradigm for a pretty long period.


Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>