“When one side of a story is heard and often repeated, the human mind becomes impressed with it insensibly” – George Washington
Daughter- Can I go out with friends?
Father- Have you asked your mother?
Daughter- Of course I have.
Father- Okay, have fun.
In the plot above, the daughter only tells her father half of the truth. She fails to disclose that her mother said “no.”
Like the daughter’s craftiness, many markets are surging on narratives built on just one side of a story. For speculators and gamblers, that seems to suffice. For investors aiming to build and preserve long term wealth, we suggest understanding every side of a story.
Of the many tales we hear to justify record equity valuations, low-interest rates are among the more popular. Make no mistake, low interest rates provide benefits to stock prices. However, that is only half of the truth. We now present the other half of the story that few tell.
Opportunity Cost
There is a popular narrative that says stocks should do well simply because bond yields are pitifully low. The basis behind the argument is simple math comparing historical stock returns versus current bond yields. The fact of the matter is that historical average returns and expected stock returns are often quite different.
The calculation of expected returns is primarily a function of the price of an asset. The higher the price paid, the lower your expected returns and vice versa.
As we wrote in “You’ve Got To Ask Yourself One Question. Do You Feel Lucky?” current expected equity returns are near 0, as valuations are extreme. Statistically based expected returns are vastly different than the “we hope for” expected returns spewed by cheerleaders in the financial and social media outlets.
The article presents four popular valuations methods and the expected returns based on the historical relationship between valuations and 10-year forward returns. In each case, the current valuation has a strong statistical correlation with the coming 10 years of returns.
We extend that analysis by comparing those return expectations to yields on Treasury and corporate bonds.
The intersection between the same color vertical and trend line denotes the expected return for the respective valuation method. We show Ten-year U.S. Treasury yields and BBB-rated corporate bond yields with the dotted horizontal lines.
The table below the graph summarizes our findings…CLICK for complete article
