The most frequently asked question right now is how the presidential election is going to impact the stock market. What is really being asked is, “Should I sell out now and get back in later?” Who knows what is going to happen in the market…
Here’s what we do know. While everyone continues to ask the question about how overvalued the market is and how volatile it might be over the coming year, we continue to ignore just how overvalued the bond market is.
Investors generally regard Treasurys as offering a risk-free return (though all investing involves risk), but is that true in this environment? Let’s do some quick math on a hypothetical 10-year Treasury:
- Current Nominal Yield on 10-Year Treasury: 0.81%
- Illustrative Marginal Tax Rate: 32%
- Inflation Expectation: 2%
The Math: 0.81% x (1 - 0.32%) = 0.55% - 2% = -1.45%
In other words, if an investor in the 32% tax bracket holds today’s 10-year Treasury for 10 years with inflation of 2%, the average annual real return is approximately negative 1.4%.
Can we call it risk-free return if the real return expectation is negative?
As I said in a previous post, according to Howard Marks, about 80% of bonds are yielding less than 1%. If this is true, then we can assume that about 80% of bonds have negative real return expectations.
In a world where you depend on your income keeping up with inflation, real return is all that matters.
Making this scenario look even bleaker than it already does - this is before even considering the idea of interest rates rising from historically low rates where they currently reside. If this occurs, current Treasury offerings will continue to offer negative real returns with price declines coming along for the ride.
And yet, here we are with investors worrying about the stock market where the dividend yield is currently 1.75% which has historically averaged about a 5% - 6% annual dividend increase, not to mention the potential capital appreciation to boot.
Perhaps this time is different, just not in the way that people generally insinuate when they say that. The choices at this point may be as obvious as ever.
Stay the course,
This price decline could occur because there is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.
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This post is not advice. Please see additional disclaimers.