Goldman Sachs Predicts 4.5% 10-year Treasury Yields

Goldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period.  The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.

Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years.  If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds.  If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.

Historical Perspective

This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.

Source: The Big Picture blog

Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier.  From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.

Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years.  Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards.  If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.

Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation.  During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy.  The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.

What Has to Happen for Goldman’s Outlook to Play Out?

To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth.  In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation.  This has been the prevailing state of the U.S. economy over the last fifty years.  Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s.  If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.

Related Links:

• Investing Implications or Trends in Household Wealth
• Low Beta Market Sectors
• REITs and the Rally of 2014

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How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

REIT Yield as a Predictor of Future Returns

The yield of an asset is a key component of predicting future returns.  This is true for the yield on Treasury bonds as well as the dividend yield for stock indexes.  The yield on aggregate bond indexes is considered a good proxy for future expected returns.  The dividend yield of broad stock indexes has been shown to provide significant value in predicting future stock index returns.  In both cases, low yields tend to predict high future returns, and vice versa.  These arguments that yields predict returns are not without critics, especially for equities. 

The Meaning of the New Highs in the S&P500

The S&P500 has recently been hitting new all-time highs, which would seem to suggest that the economy is recovering and that the U.S. economy is back on track.  The story does not look quite so rosy when you account for inflation, as Mark Hulbert has recently noted.  The current level of the S&P500 is, in fact, still about 24% below its high in 2000 once inflation is considered.  Economists and finance people would say that, measured in real terms, the S&P500 is 24% lower than it was at its 2000 peak.  What this means is that the proceeds from the sale of a share of an S&P500 index fund purchases considerably less in real goods today than it did thirteen years ago. 

Review of The Affluent Investor by Phil DeMuth

I have known Phil DeMuth for a number of years and I admire his common sense and views on many topics.  Phil authored the recently-published book The Affluent Investor that fills a need in the crowded shelves of investment books.  As a financial advisor to high-net-worth families, Phil brings valuable perspective to investors who have built substantial portfolios and seek to protect and grow their wealth effectively.

The Yield Paradox

I have been struggling to understand a problem that I am going to refer to as the ‘yield paradox.’  Yields for individual asset classes look low.  The 10-year Treasury bond is yielding about 1.9%, and 30-year Treasury bonds are yielding a similarly paltry 3%.  The S&P 500 is yielding 2.1%, which is very low by comparison to historical levels.  Investment-grade corporate bond indexes are yielding less than 4% (see LQD, for example, at 3.8%).  Given that the official rate of inflation for 2012 was 1.7%, these yields mean that investors are getting very little yield net of inflation.  The very low yields on bonds and on stock indexes is a direct result of the Fed’s actions in holding interest rates at historical lows via Quantitative Easing.  We have not yet gotten to the paradox.

Apple’s Share Price and Behavioral Finance

The price of a share of Apple (AAPL) is almost 30% below the high that it set back in September 2012—about five months ago.  Even before its peak, the price of Apple shares had already made it the most valuable company in history.  In those heady times, Apple shares reached $702.  Today, they are at $503.  Even today, however, Apple remains the largest single holding in the S&P 500 at about 3.6% of the total index.  It is mind boggling to consider that the market value of the most valuable public firm in history could decline by 30% in five months, without some sort of catastrophic event.  But this is the situation and there are some lessons to be drawn.

One Advisor’s Approach to Income Investing

Guest post by Contributing Editor, John Graves.

Editor’s Note:  John Graves has been an independent financial advisor for 26 years. He is one of the two owners of The Renaissance Group, a Registered Investment Advisor based in Ventura, CA.  John’s book, The 7% Solution: You Can Afford  a Comfortable Retirement, was published in 2012.  When I read this book, I was impressed with John’s approach and thinking and I recommend it as a good read.  I contacted John and asked if he would consider contributing to this blog.  After we bounced around some possible topics, he sent me the following piece that describes his process for designing income plans for retirees. 

A Thoughtful Outlook for 2013

In general, I ignore the spate of market predictions that experts issue at the start of each year.  There are exceptions, and after reading Jason Hsu’s outlook for this year, I am pleased to recommend it to readers.  Dr. Hsu is the Chief Investment Officer at global money management firm, Research Affiliates.  I found his article both insightful and appropriately skeptical of all forecasts.  How can you not appreciate a money manager who starts his prediction for the year ahead with John Galbraith’s quip that “the only function of economic forecasting is to make astrology look respectable”?

I am going to mention a few of the elements of Hsu’s outlooks and add some thoughts.  Hsu first examines the drivers for bonds and then equities.  I will follow this structure.

Investing for Income vs. Total Return

One of the most-discussed issues in long-term investing is whether to focus on income generation or simply to think in term of total return (price gains plus income).  The discussion of this topic often focuses on whether investors should seek out stocks that pay dividends vs. simply planning to sell a fraction of their portfolio periodically to provide income.  I recently wrote a long article on this topic, which has been cited in a very interesting discussion of this theme going on at Bogleheads.    One of the most active participants in the debate on the Bogleheads forum and elsewhere is Larry Swedroe, a well-known advisor and author.  As I read the Bogleheads discussion thread, it strikes me that there is considerable confusion around this topic, so I thought I would add a few more thoughts.