With bond yields surging to 4.7%, T-notes are looking like a better deal than the pricey S&P, says the Research Affiliates' formula

With bond yields surging to 4.7%, T-notes are looking like a better deal than the pricey S&P, says the Research Affiliates' formula

Recent analyses indicate a shift may be in order from equities to fixed income. A valuable resource for identifying promising investment categories worldwide is the Asset Allocation Interactive tool provided by Research Affiliates. With oversight of $188 billion in investment strategies primarily focused on mutual funds and ETFs, Research Affiliates also supplies methodologies for RAFI funds offered by notable firms such as Invesco, Charles Schwab, Pimco, and State Street. The firm’s founder and chair, Rob Arnott, a respected figure in academic finance and former editor of the Financial Analysts Journal, leads a team renowned for attracting top-tier PhDs in finance. At the core of the model utilized by Asset Allocation Interactive lies a straightforward yet impactful principle: "buying at extremely rich prices usually leads to poor outcomes in subsequent years, and vice versa."

This perspective differs significantly from the prevailing narratives in Wall Street, making it a valuable guiding principle, particularly amidst the current market climate that has driven the S&P to reach an unprecedented high on May 14—an increase of 22% over the past year, compounding an already extraordinary valuation.

The dynamics highlighted in the Asset Allocation Indicator are primarily influenced by a significant increase in yields, which has rendered traditionally stable Treasuries—like the 10-year note, now at 4.7%—more appealing, while the surge in U.S. large-cap stocks has collectively diminished their attractiveness as investment opportunities. The stark disparity between the reduced potential in the equities market and the increased allure of fixed-income options indicates that Treasuries, and even cash investments, now appear more favorable than the S&P 500 in general, especially compared to high-performing stocks within the so-called "Magnificent Seven."

Why big cap tech stocks come in dead last among all investment choices right now

Asset Allocation Interactive evaluates projected returns for roughly 40 different asset categories over the next decade. This comprehensive array includes bonds such as Global Corporates, U.S. High-Yield, and TIPs, as well as a variety of stock portfolios categorized by growth and value across both developed and emerging markets, further segmented into large and small caps, along with U.S. REITs and diversified European holdings.

To forecast expected annual returns from equities, the Interactive tool combines the current dividend yield with anticipated growth in earnings per share (EPS), while adjusting for valuation fluctuations, applying a mean reversion concept for price-to-earnings (PE) ratios. Specifically, the methodology assumes that from current levels, the PE multiple will revert halfway to its historical average over the decade. This approach is conservatively framed in the context of today's market, as the S&P PE is significantly higher than its average, such that a 50% reduction would still maintain a relatively elevated level.

Current projections from the Interactive suggest that U.S. Large Caps will yield a mere 3.2% annual return up until May 2036. When adjusted for an expected inflation rate of 2.6%, the “real” return drops to just 0.6%. Predictions are even bleaker for U.S. Large Cap Growth stocks, expected to produce a minimal 1.7% return per year, falling short of the Consumer Price Index (CPI) by nearly 1 percentage point. Notably, within the extensive categories assessed by the Interactive tool, U.S. Large Cap Growth ranks at the bottom. The "Magnificent 7," which dominates this segment, significantly contributes to this unfavorable position, with the group collectively carrying an extraordinarily high PE ratio of 38—one that the Interactive model forecasts will decline.

This situation presents a notable contrast, especially considering the historical advantage equities typically maintain, except during certain unusual market conditions. Currently, Treasuries and cash outperform the S&P 500 (U.S. Large Cap) and particularly excel against the Large Cap Growth sector led by prominent companies like Nvidia, Alphabet, and Tesla. A portfolio consisting of Intermediate Treasuries with maturities between 3 and 10 years is projected to yield 4.6% annually, comfortably surpassing inflation by almost two percentage points. Even investments in "Cash," utilizing 30-day commercial paper, would provide a return of 3.5%, exceeding the cost-of-living rate by 0.7%.

Consequently, Research Affiliates anticipates that Treasuries will provide nearly three percentage points more than Large Cap Growth (4.6% versus 1.7%), while investing in Commercial paper would yield even better results (3.5% compared to 1.7%). Importantly, the Interactive tool highlights numerous global markets where returns should surpass those of Treasuries or cash, including undervalued areas such as Emerging Markets Value, Europe, and U.S. Small Cap. While the tech sector has experienced remarkable gains, Research Affiliates' compelling analysis suggests that opting for safer, more stable investments might be the wiser choice moving forward.