Day after day we are brain-washed with the mantra of equity dividend yields being greater than treasury yields implies 'cheapness' or "who wants a 2% return from treasuries?". While we have tried again and again to put this dead-end of apples-to-unicorns valuation to bed, SocGen has an excellent treatise on the subject that should make all but the most ardent Bill Miller fan comprehend the ultimate risk-reward trade-off.
At its simplest level, comparing a risky instrument with an inherently risky cash-flow stream (equities and dividends) to a risk-free (at least from a get-back-your-money basis) should be a red flag for any valuation approach - no matter how ingrained it feels. While describing risk is always prone to complexity and argument, the chart below shows that based on current levels equities (SPY) are 32% (orange line) more volatile (risky) than TSYs (TLT). At the same time, the relative yield advantage (black line) is 10.8% higher in stock dividend yields vs TSYs - so a 3:1 risk-to-reward ratio for the switch from bonds to equities.
Of course capital appreciation 'potential' is the main argument against this simple approach and that is where SocGen's excellent article comes in.
Sub 2% bond yields offer miserable nominal returns, but equities always carry the risk of massive drawdown. Major losses on bonds typically stem from inflation eroding returns, not major price declines. Nominal bond drawdown has rarely exceeded 10% on a 5-year rolling basis.
Let's put the relative risk attraction of bonds and equity returns into context. The five year maximum drawdown of US Treasuries and US equities on a nominal return basis is shown above. The point here is to show just how much more risky equities are versus bonds when it comes to losing money. Equity investors have seen several periods of substantial drawdown, whilst on a nominal return basis, which is the only thing that matters when marking to market, bond drawdown has been much more limited.
And so to longer-term investing and the benefits of buy-and-hold:
How regularly each asset inflicts pain on the holder is shown below. Here we make the assumption that you buy and hold each asset for a five-year period. We then ask the question, how many times, if investing on a monthly basis, since 1950, would you have taken a 20%, 30%, 40% or 50% drawdown?
They succinctly summarize the asset allocation decision as follows:
The bond investor could have bought bonds 90% of the months since 1950 and avoided having a 20% drawdown or more, whilst the equity investor could have only invested in 40% of months to avoid such losses. Extreme drawdown of 40% or more, even on a real basis, is almost unheard of in the bond market, but seen 17% of the time in equities. Yes bonds at sub 2% offer miserable returns, but equities will always offer a higher probability of major losses and until we have an investor base that is able to take such losses, low yields and a systematic preference for bonds is likely to be with us for a while. Risk capital will also be in short supply - if you have it, better use it wisely.
As Boomers head into an uncertain retirement, we wonder whether this type of 'realistic' analysis will trickle-down to investor expectations and 401(k)s as the triangle of risk-reward-regret becomes more and more prescient every day.