Stocks vs. Bonds - A Historical Perspective^©

By Robert G. Kahl

August 4, 2002

(Note: To view associated charts, use the links at left to open in chart in this window or use links in article to open chart in a new window).

The purpose of this article is to provide a historical overview of the changes that have taken place between the valuations of stocks and bonds.  The Federal Reserve's stock valuation model will also be reviewed for its use as an asset allocation tool.

The Federal Reserve's stock valuation model has received some publicity in recent years because it indicates that stocks are currently overvalued.  The Fed's model involves a simple comparison between the earnings yield of the S&P 500 Composite Index, using forecasted earnings for the next 12 months, and the yield on the ten year U.S. Treasury bond.  For this article, I have used a modified version of the Fed's model.  Trailing (most recent twelve months) earnings are used to calculate the earnings yield, because information was available from Standard & Poor's on reported earnings but not forecasted earnings.  The 5 year U.S. Treasury bond is substituted for the ten year bond.  Ibbotson Associates provides total return calculations and year-end yields for the 5 year and 20 year U.S. Treasury bonds only.  The 5 year bond was used, as the duration (a measure of sensitivity to changes in interest rates) is closer to that of the S&P 500 Index.

S&P 500 Earnings and Dividends

Chart 1 shows earnings and dividends for the S&P 500 Composite Index from 1926 through 2001.  During the 1920's, earnings peaked in 1929 at $1.61 and did not return to that level until 1947.  From 1947 to 2001, S&P 500 earnings increased at a fairly steady rate from $1.61 to $24.90.  The annual compound rate of growth from 1947 to 2001 was 5.1%.

Dividends for the S&P500 Composite Index experienced a similar pattern with a lag.  Dividends peaked in 1930 at $0.98 and did not surpass that level until 1949.  Corporations were reluctant to reduce dividends at the start of the Depression so dividends exceeded earnings for the three years 1930-1932.  From 1947-2001, S&P 500 dividends grew at a compound growth rate of 5.5%, slightly higher than the earnings growth rate of the period.

Relative Valuations

Significant changes in relative valuations between stocks and bonds have taken place over the years.  Chart 2 shows that the S&P 500 earnings yield (earnings/price) and dividend yield (dividends/price) have changed over time relative to the yield available on the 5 year U.S. Treasury bond.  The data points shown are at year-end.  For the 41 years from 1926 through 1966, the earnings yield at year-end exceeded the bond yield.  The difference in favor of stocks reached a high at the end of 1948 when the earnings yield (15.1%) exceeded the bond yield (1.5%) by 13.6%.  Since 1980, the bond yield has exceeded the earnings yield at the beginning of each year with the exception of 1995.

At the end of 1999, the S&P 500 dividend yield was at its lowest level since Standard & Poor's started collecting data in 1926.  The S&P 500 earnings yield reached its lowest level at the end of 2001.  At the end of 2001, the bond yield exceeded the earnings yield by 2.25%.

Relative Yields and Relative Returns

Chart 3 is a scatter diagram.  The x-axis represents the difference between the earnings yield and bond yield at the beginning of each year.  The y-axis represents the difference between the S&P 500 total return and the 5 year U.S. Treasury bond return for the corresponding year.  While there appears to be a positive relationship between the two, there is a high dispersion for the data points.

The relationship seems to have more relevance when the earnings-bond yield difference is at extreme levels.  For the twelve years when the earnings yield exceeded the bond yield by 6% or more, stocks outperformed bonds in nine of the years and the average difference in annual returns was 14.3%.  For the four years when the bond yield exceeded the earnings yield by 2% or more, bonds outperformed stocks in three of the years and the average difference in annual returns was 10.5% in favor of bonds.

The Fed's Stock Valuation Model

For the period 1926-2001, the total return on the S&P 500 Composite Index exceeded the total return on the 5 year U.S. Treasury bond by 5.4% (using geometric averages).  How would an investor have fared if they had switched from stocks to bonds based upon a comparison of the earnings yield to bond yield?  During the years 1926-2001, if an investor had switched from the S&P 500 to the 5 year U.S. Treasury bond when the bond yield exceeded the (trailing) earnings yield and vice versa, he would have a lower total return than if he had remained invested in the S&P 500 during the entire period.  Based upon a comparison of annualized geometric averages, the opportunity cost would have been 0.5%.

Historical Returns
1926-2001

	S&P 500 Composite Index	5 Year U.S. Treasury Bond	Allocation Based Upon Highest Yield
Arithmetic Average	12.7%	5.5%	11.9%
Geometric Average	10.7%	5.3%	10.2%
Standard Deviation	20.2%	5.7%	18.6%
# Years w/ Highest Return	49	27	44

The Federal Reserve's stock valuation model has had poor predictive ability during several time spans.  A switch between asset classes based upon a comparison between the S&P 500 earnings yield and the 5 year U.S. Treasury at the beginning of each year would have provided the correct signal in 44 of the 64 years.  The wrong signals are concentrated in three time spans.

The Fed model would have continued to favor stocks during 1929-1932 when the earnings yield continued to be higher than the bond yield because earnings declined by 74.5% and stock prices declined at roughly the same rate.  Few investors at the time correctly anticipated how far earnings would decline and how long it would take earnings to recover to the levels seen in 1929.

From 1939-1941, the Fed model favored stocks, which under-performed the U.S. Treasury bond.  S&P 500 earnings rose modestly during this time, but investors demanded a larger risk premium because of World War II and the gap between the earnings yield and the bond yield increased to 10.2% by the end of 1941.  For the years 1942-1945, earnings were flat but the risk premium declined and stocks outperformed bonds in each of the remaining war years.

During the fifteen years from 1985 to 2001, the Fed model favored bonds with the exception of 1996.  The model would have provided the correct signal in only five of those years (1990, 1993, 1996, 2000, and 2001).  From the start of the bull market in 1982 through 1999, S&P 500 earnings increased at an annual compounded rate of 7.7%.  The earnings yield, however, fell from 12.5% at the end of 1981 to 3.3% at the end of 1999.  A significant portion of the high returns realized by stock investors were due to lower interest rates and higher valuations placed on corporate earnings.

Conclusion

When establishing asset allocation, investors should consider how the relative valuations between stocks and bonds have changed over time.  Although the Federal Reserve's stock valuation model has poor predictive ability, investors should consider modifying their asset allocation when there are large differences between the earnings yield and bond yield.

References
1. Ibbotson Associates.  Stocks, Bonds, Bills, and Inflation 2002 Yearbook.  Chicago, IL: Ibbotson Associates, 2002.

2. Standard & Poor's.  Current Statistics.  New York, NY: Standard & Poor's, June, 2002.

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