With Financial Samurai, there’s a strong correlation between the number of articles written and the amount of traffic the site receives. I can spend more time building rapport with readers by responding to comments. I can also write guest posts on other sites to widen Financial Samurai’s reach.
With a real estate investment, I can paint the interior and exterior, refinish the floors, change the fixtures, landscape the front and back yards, expand the livable space, keep up with market rents, find higher-paying tenants and so forth. Then when rates get low enough, I can refinance my mortgage to improve my cash flow.
But with stocks, you and I are minority investors with no say. We are at the mercy of exogenous and endogenous variables. Maybe Trump will announce an all-out trade assault on China. Maybe a CEO will be found guilty of embezzlement. Maybe there will be some type of data breach. Or maybe Amazon or Google will announce they are entering your space.
Yet, investing in the S&P 500 over the long term has proven to be one of the best ways to build a fortune as well. Therefore, all of us should have some exposure to the S&P 500. It’s the amount of exposure that is up to all of us to decide.
A Buy Signal May Be Flashing In The Stock Market
We’ve discussed the importance of taking advantage of arbitrage opportunities in a previous post. There are kinks in the system that can be exploited every day.
If you’ve got cash lying around, it’s a no-brainer to take advantage of online savings rates that are way higher than the current 10-year bond yield. I’m not going to leave any cash in my main transaction bank, Citibank, because they are only paying me a savings rate of 0.04%. Pathetic!
But what if you want to take more risk because you’re willing to lose money in order to gain more money? The S&P 500 is one of the easiest risk asset for anyone to buy. We know that the S&P 500 has provided a 5.6% compound annual return between 1999 – 2019, and close to a 10% compound annual return from 1926 – 2016.
There is one indicator that has historically shown to be a buy signal for S&P 500 bulls: when the S&P 500 yield is higher than the 10-year bond yield. This unusual occurrence happened recently.
Given the S&P 500 has historically outperformed the 10-year Treasury bond in terms of principal appreciation, investors start to get interested when the S&P 500 yield alone is higher than the 10-year Treasury bond.
An S&P 500 investor can view the yield as either a bonus or a buffer. For example, if the S&P 500 appreciates by 10% and you also get a 1.5% yield for an 11.5% total return, you can view the yield as a bonus.
If the S&P 500 declines by 10% and you get a 1.5% yield for a total negative return of 8.5%, you can view the yield as a buffer. Your view depends on the direction of the market, your general disposition, and your risk tolerance.
Right now is tricky because the S&P 500 is close to an all-time high, yet the S&P 500 yield is now higher than the 10-year yield as of September 2019.
Do you view the yield as a bonus or as a buffer? Given I’m a conservative investor who doesn’t want to go back to full-time work, I view the S&P 500 yield more like a buffer in case of a pullback.
During the 2009 financial crisis, the 10-year bond yield collapsed as investors sought the safety of bonds. But notice how the S&P 500 dividend yield irrationally soared before collapsing as companies decided to conserve cash by cutting their dividend payouts.
If a rise in the S&P 500 yield is seen as an ominous sign for equities, then S&P 500 bulls should find solace in today’s S&P 500 yield data that shows a steady 1.7% – 2.1% yield since 2010.
At the same time, a 10-year bond yield below the S&P 500 yield makes the S&P 500 incrementally more attractive. What is an S&P 500 investor supposed to do?
Based on the analysis by Renaissance Macro Research (RenMac), the Sharpe Ratio is 100% higher and the annualized return is 68% higher when using yields as a buy/sell signal for stocks versus bonds.
In other words, the data is showing that when the S&P 500 yield is higher than the 10-year bond yield, one should be an incremental buyer of the S&P 500 index.
Do You Believe In The Buy Signal?
As you can tell from the S&P 500 / 10-year bond yield analysis, it’s not as straight forward as saying, “Buy panoramic ocean view properties in San Francisco because they are irrationally trading at a discount to the median-priced property, whereas panoramic ocean view properties in other major cities trade at tremendous premiums.“
Real estate is so much easier to understand, which is why for most people, I think real estate is the better want to build long-term wealth.
The argument to buy the S&P 500 at all-time highs, despite its yield being higher than the 10-year bond yield, is much more nuanced because there are so many more tea leaves to read.
The very next day, the 10-year bond yield could be way higher than the S&P 500 yield. Then what? Sell all stocks and build a bunker, especially since the S&P 500 is way above trend?
To finalize the arbitrage trade, some professional investors would say one should short the 10-year Treasury bond given there could be a reversion to the mean. Based on the first chart, very rarely does the 10-year bond yield stay below the S&P 500 yield.
Despite the murkiness of the S&P 500 yield versus 10-year bond yield indicator, it is comforting for stock investors to know that rational money will start slowing shifting out of bonds and into stocks due to the relative value the S&P 500 now provides.
All we really know for certain is that the S&P 500 has provided investors a positive return over the long run. Therefore, we should all have some type of exposure and continue to dollar-cost-average over the long run.
Readers, do you think the S&P 500 yield > 10-year bond yield is a good buy signal for stocks? Do you think the S&P 500 yield will come down or the 10-year yield will go up or both, to get this kink back to normal? What are the tea leaves telling you?