For the first time in roughly a quarter of a century, the 10-year US Treasury yield has climbed above 5%, pushing the appeal of bonds relative to equities to its strongest level in about 25 years.

Measured by the inverse of the S&P 500's price-to-earnings ratio, the stock earnings yield has now fallen below the 10-year US Treasury yield, meaning bonds have gained a clear upper hand over stocks on the income front. This shift poses potential downward pressure on the equity market.

The cyclically adjusted excess CAPE yield model developed by Yale University economist Robert Shiller suggests that over the next decade, the S&P 500 may outperform bonds by only about 1% per year. Investors' margin for error on corporate earnings expectations has narrowed considerably.

Long-bond investors take heavy losses as bubble burst becomes evident

High yields are, to some extent, a sign of economic resilience. US stocks sit near record highs, the American economy is performing better than expected, and the impact of rising long-end rates has yet to fully show up at the macroeconomic level.

Yet those feeling the pain first are investors who had bet on long-dated bonds. Taking the TLT ETF, which tracks US Treasuries with maturities of 20 years and above, as a reference, these investors have suffered substantial losses. Looking back, the bond bull market fueled by a decade of low inflation and government intervention after the financial crisis, along with the sharp price surge during the pandemic, now appears to have carried clear hallmarks of an asset bubble. Market patterns suggest that when a bubble bursts, it often signals a buying opportunity. The current 10-year Treasury yield above 5% is a level rarely seen in decades, and the allocation value of bonds has been substantially repriced.

The yield inversion logic has ended, and the two-decade paradigm of stocks beating bonds has been broken

The old market orthodoxy held that stocks, with their growth potential, deserved a valuation premium over bonds, meaning the stock earnings yield should naturally sit below the bond yield. But for roughly two decades after the global financial crisis, that logic was turned on its head, with the stock earnings yield staying above the bond yield for an extended period, making equities the undisputed favored asset.

Now the situation has reversed once again. Comparing the stock earnings yield with the 10-year US Treasury yield, the relative appeal of bonds has returned to levels last seen about 25 years ago. This means that even though equity valuations have already compressed somewhat to absorb higher bond yields, the outlook for stocks still faces certain pressure.

The Shiller model sounds a warning, but its historical limitations also 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 show the indicator has significant predictive power for ten-year equity excess returns, and the current reading implies the S&P 500 will outperform bonds by only about 1% per year over the next decade.

However, the model's forecasting accuracy has declined in recent years, with actual stock market performance far exceeding its projections, possibly due to sustained policy intervention in the market. Even so, the core signal remains clear: the substitution value of bonds is the highest in a generation. Against this backdrop, investors need to scrutinize S&P 500 earnings growth forecasts with far stricter standards, because if corporate profits fall short of expectations, the bond market will no longer provide any cushion.

Risk warning and disclaimer

Markets carry risk, and investing requires caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their particular circumstances. Any investment made based on this article is at the user's own risk.