Why buy risky stocks when boring bonds offer similar results right now

The stock market has a problem. It’s called math.

On the one hand, bond yields are surging higher. Higher yields make bonds more attractive compared with shares.

On the other hand, mammoth amounts of capital are flowing into the artificial intelligence sector. Earnings, though, have yet to start flowing out.

Put rising bond yields and AI’s questionable economics together and the math supporting today’s lofty stock prices begins to look shaky.

For now, investors are waiting to see what happens next. Both the S&P 500 index in the United States and the S&P/TSX Composite Index in Canada have barely budged in four months.

But don’t mistake that stability for complacency. Investors are nervous. You can see that in the recent rash of delayed initial public offerings from companies as varied as smart-ring maker Oura, nuclear-services expert Holtec and Bamboo Insurance.

The anxiety is also evident in declining market breadth. In both Canada and the U.S., a handful of companies are powering most of the market’s gains. While broad stock market indexes are still hovering near record highs, the reality for many individual companies is far grimmer. Thirty-eight per cent of S&P/TSX Composite companies and 43 per cent of S&P 500 companies are 20 per cent or more below their 52-week highs, according to Bloomberg.

One major reason for this creeping malaise is the bond market. Bond yields, which ultimately determine everything from mortgage rates to what you pay for a car loan, have been on fire in recent months. This week, the yield on the world’s most widely followed bond-market benchmark, the 10-year U.S. Treasury bond, hit its highest level since 2002.

Bonds in many other advanced economies are making similar big moves. Surging bond yields are reshaping the market landscape, undermining the case for stocks.

The change is dramatic. For years following the financial crisis, bonds delivered paltry payoffs. Stocks offered a much better deal even if you ignored their potential for growth and focused simply on the dividends they paid out.

Five years ago, for instance, a 10-year Canada bond was yielding a mere 1.5 per cent. Meanwhile, Royal Bank of Canada shares – the safest, surest bet in Canadian equities – were paying double that amount in dividends. Given the disparity in yields, it was obvious what a smart investor should do: Buy the bank shares.

Now? The math has reversed. The 10-year Government of Canada bond is yielding nearly 4 per cent while Royal Bank shares are paying only about 2.5 per cent in dividends.

To be sure, Royal Bank has a proven ability to increase its dividend over time, which makes it worth more than just a simple comparison of yields would suggest. But at least in terms of short-term payouts, bonds now look like a surprisingly reasonable alternative to blue-chip stocks.

A similar point holds true across the border. After the big run-up in bond yields, investors can now earn a touch over 5 per cent a year from a 10-year U.S. Treasury bond. That is more than four times the meagre 1.1-per-cent dividend yield on the S&P 500.

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Again, one has to be careful with simple comparisons. Companies are increasingly using share buybacks, rather than dividends, to return earnings to shareholders.

Still, the 10-year U.S. Treasury yield looks attractive even if you compare it to the S&P 500’s earnings yield, a more inclusive measure of value creation than just dividends alone.

The earnings yield is the inverse of the more widely used price-to-earnings ratio. In other words, it’s what you get when you divide a stock’s earnings by its price, rather than the other way around. When the stock market is trading for 20 times forecast earnings, as it is now, its earnings yield is 5 per cent.

That, as it happens, is just about identical to the yield on a 10-year U.S. Treasury. Remarkable, isn’t it? After years of miserly bond payouts, humdrum U.S. government bonds are now offering a deal that seems roughly on par with the far more glamorous stock market.

For stock investors, this poses a challenge. No sane investor wants to buy risky stocks if they can get similar results with safe, boring government bonds.

The only way for the stock market to shine in this high-yield environment is for corporate earnings to grow even faster than already boisterous expectations.

But this is where things get truly tricky. Many of the market’s big recent winners have been in the AI sector. In fact, so much money is pouring into AI that it is on track to becoming the largest capital-expenditure boom in U.S. history, according to a recent paper by Stijn Van Nieuwerburgh of Columbia Business School.

Yet actual earnings have been hard to find. Since 2024, a half-dozen firms – Alphabet Inc., Amazon.com Inc., Microsoft Corp., Meta Platforms Inc, Oracle Corp. and Space Exploration Technologies Corp. (better known as SpaceX) – have spent about US$1.2-trillion on AI investments, according to economists Jared Bernstein and Ryan Cummings. The problem is that these “hyperscalers” have only brought in only $277-billion in revenues. That leaves a gap, so far, of about a trillion dollars, the economists calculate.

The math here is not attractive. Perhaps bond yields will tumble in months ahead and AI projects will begin to gush profits. If not, the year ahead will be interesting.