Rare in 25 years! The 10-year U.S. Treasury yield surpasses the S&P 500 earnings yield

The yield gap between bonds and stocks has reversed to the most bond-favorable level in 25 years, a structural shift that is forcing investors to reevaluate asset allocation strategies.

The 10-year US Treasury yield has broken above 5%, making bonds comparatively more attractive than stocks at the highest level in about 25 years. Measured by the inverse of the S&P 500 price-to-earnings ratio (earnings yield), equities now yield less than the 10-year US Treasury, meaning bonds are now clearly suppressing stocks in terms of returns.

This situation poses potential downside pressure on the stock market. According to Yale University economist Robert Shiller’s cyclically adjusted excess CAPE yield model, the S&P 500 may only outperform bonds by about 1% annually over the next decade. The margin for error in investors' earnings expectations for companies has tightened significantly.

Long-term bond investors suffer heavy losses, clear signs of bubble burst

High yields in some respects are a reflection of economic resilience—US stocks are near historical highs, the US economy has outperformed expectations, and the shock of rising long-term interest rates has yet to be fully felt at the macro level.

However, those who previously bet on long-term bonds have come under pressure first. Looking at the TLT ETF, which tracks US Treasuries of 20 years or more, these investors have already suffered substantial losses.

Looking back, the bond bull market fostered by a decade of post-crisis low inflation and government intervention, as well as the price surge during the pandemic, are now seen as exhibiting clear asset bubble characteristics.

Market patterns suggest that a bubble burst often signals a buying opportunity. The current 10-year Treasury yield above 5% is a rare occurrence in decades, and the allocation value of bonds has been substantially re-rated.

End of yield inversion logic: the twenty-year paradigm of stocks outperforming bonds has been broken

The former market orthodoxy was that stocks, due to their growth potential, should command a valuation premium over bonds—that is, equity earnings yields should naturally be lower than bond yields.

However, for about twenty years following the Global Financial Crisis, this logic was completely overturned—equities delivered earnings yields significantly higher than bond yields, making them the undisputed superior asset.

Now this situation has once again reversed. Comparing equity earnings yields to the 10-year US Treasury yield, the relative attractiveness of bonds has returned to where it was about 25 years ago.

This indicates that even though equity valuations have compressed to absorb higher bond yields, the outlook for stocks remains under some pressure.

The Shiller model gives a warning, but its historical limitations deserve attention

Robert Shiller’s excess CAPE yield indicator forecasts stocks’ excess returns over the next decade by comparing the cyclically adjusted real earnings yield with the 10-year Treasury yield.

Historical data shows this indicator has significant predictive power for ten-year future equity excess returns, and the current reading suggests the S&P 500 will outperform bonds by only about 1% per year over the next decade.

However, the predictive accuracy of this model has declined in recent years—the stock market has far outperformed its forecasts, which may be related to ongoing policy interventions in the market.

Nevertheless, the core signal remains clear: the substitution value of bonds is at its highest in a generation. In this context, investors need to scrutinize S&P 500 earnings growth projections with greater rigor, as any disappointment in corporate profitability will find little buffer from the bond market.