Do you know how long a nanosecond is? It's less than a millisecond and more than a picosecond. A nanosecond is also about the amount of time Warren Buffett said it would take him if he had the choice "...between buying the S&P 500 Index or buying the 10-year U.S. Treasury, 30-year US Treasury."
That's the equivalent of a ringing endorsement for stocks from the world's greatest investor, so why do other investors seem to be dragging their feet right now buying the S&P 500 Index, which is only up 1.5% year-to-date on the heels of the best quarter of earnings growth (+24.5%) since 2010?
The answer may just be wrapped up in the 10-yr U.S. Treasury, the 30-yr US Treasury, or, frankly, Treasury securities with a much shorter duration.
Long on Significance
The stock market has had a manic disposition this year, having acted excitedly at times and anxiously at others -- sometimes in the same day, if not the same hour.
We have spent time in this column offering some perspective on why that has been the case. In mid-April, however, we pinned the primary source of volatility on the shift in the Federal Reserve's policy perspective.
That shift has driven up interest rates at the short end of the Treasury yield curve, which is something that just might be long on significance for why this bull market seems to be grazing like a cow instead of charging like, well, a bull.
Notwithstanding the excellent earnings growth, we highlighted several factors a few weeks ago that have seemingly contributed to the persistence of a range-bound market.
The increased competition for stocks from higher short-term (and risk-free) rates was one of them. We pointed out then how the 2-yr note yield was 40 basis points higher than the S&P 500 dividend yield. Today, the 2-yr note yield of 2.54% is 51 basis points higher than the S&P 500 dividend yield of 2.03%.
The real gist of the competitive matter for the stock market, though, is that investors don't have to go that far out on the curve to get a risk-free return that exceeds the dividend yield of the S&P 500. They can do that with a 6-month T-bill, which yields 2.08%.
We Have Our Reasons
Why would stock investors be interested in owning short-term Treasury securities when this bull market has yet to be slain by the matador (that would be Fed Chair Powell by the way)?
There are several reasons and they go together:
- If investors hold Treasury securities to maturity, they don't face the risk of losing principal like they do with the stock market
- Investors will be assured of a positive nominal return; and
- Treasury securities offer peace of mind for investors who are battle-scarred from the stock market's volatile ways and are worried about rising interest rates creating downside risk for stocks
Rising interest rates do pose a headwind for stocks. On a related note, CNBC.com ran a timely article this week that called attention to Warren Buffett's reminder that interest rates are the most important item over time in valuation.
If interest rates go up, a future stream of earnings is worth less than it would be if interest rates stayed low.
Mr. Buffett's reminder might sound like a contradiction when the basis for why he would buy the S&P 500 Index in a nanosecond is that he believes "...bonds are going to fall a lot." In other words, if bonds (i.e. bond prices) fall a lot, their rates will be going up a lot given the inverse relationship between bond prices and bond yields.
What It All Means?
So, why would Mr. Buffett be so quick to buy the S&P 500 Index now?
Because buying and holding well-run, publicly-traded companies through the cyclical ups and downs has been a wealth-building virtue for him. His long-term track record obviously speaks for itself, yet he also recognizes that stocks provide superior inflation-adjusted returns, versus bonds, over the long term.
Because of his investing acumen and patient view, Mr. Buffett has a cash cushion and income stream from dividends that enables him to ride out the tough times. Many investors, however, don't have the same luxury -- and that's where the divide comes in now with the choice to buy short-term Treasury securities versus the S&P 500 Index.
With the Federal Reserve sounding pretty confident about its ability to raise interest rates, and with earnings growth at, or near, a peak, there is a reasonable basis to think that the road ahead for this bull market won't be easy and that there is more downside risk than upside potential for a bull market that is more than nine years old.
That isn't a forecast. Rather, it is an insight into why investors might find some appeal in short-term Treasuries at this juncture when earnings growth is so strong.
Whether one turns to stocks or bonds at this point will be a matter of risk tolerance and time horizon.
Warren Buffett has stood the test of time and has profited very handsomely from it. Others can, too, but everyone doesn't always have the benefit of time or liquidity that he does and can't risk the potential of short-term capital loss in the stock market.
That generates a choice, then, between buying a short-term, risk-free instrument whose maturity matches up with an identifiable cash need and buying the S&P 500 Index that might-- or might not -- deliver the cash when you need it.
It's a choice between avoiding risk and accepting risk. That's an individual choice that will take many investors not named Warren Buffett more than a nanosecond to make, yet it's a more compelling choice these days given that yields on risk-free, short-term Treasury securities exceed the S&P 500 dividend yield.
(Editor's Note: The next installment of The Big Picture will be posted the week of May 28)