3 Key Signals Say It's Time To Invest In This 'Forgotten' Market, Here's How

By now, anyone watching markets for more than a few months knows the truth: short-term market moves are anyone’s guess, but over the long haul, valuation is destiny.

When it comes to long-term opportunities in the market indexes, you’ve got to get under the hood of sentiment, valuation, and allocation. That’s where three time-tested signals come in: the market cap-to-GDP ratio (Buffett’s favorite valuation compass), aggregate investor allocation to equities (an under-the-radar sentiment gauge), and the excess CAPE yield (a rare bright light in the world of macro).

Together, they don’t just whisper. They shout.

Specifically, they shout that stocks are a loser's game, and that you need to invest in a very specific asset class.

Don't worry – doing so is easy, profitable, and pays an 8.5% yield, too.

Let’s start with the most poetic signal of them all, Warren Buffett’s beloved Market Cap to GDP.

At present, the total U.S. market cap (Wilshire 5000) sits well over 170% of U.S. GDP. Historically, a ratio over 120% indicated future annual returns well below the long-term average of ~9–10%.

At today’s stretched levels, we’re firmly in the danger zone. Past instances (think 1999) saw returns that struggled to break the mid-single digits, even before accounting for inflation.

If mean reversion is the rule (and it always eventually is), then we are looking at forward nominal returns in the neighborhood of 3–5%, possibly lower if we go full cycle and dip below the mean.

Next up, Investor Allocation to Equities, which might be the most predictive (and most ignored) signal of the three. The Federal Reserve’s Financial Accounts data tells us what share of household financial assets is in equities. Right now, that’s hovering near all-time highs at roughly 45% of assets. And here’s the rub: historically, when equity allocations are this high, future ten-year returns tend to come in very low.

A 2012 study by J.P. Morgan’s Michael Cembalest showed that the equity allocation metric was incredibly accurate when predicting subsequent ten-year returns.

At today’s levels, that model implies sub-3% real returns on the S&P 500. If you’re counting on 7–8% a year to fund your retirement, you’d better hope for a miracle, or a crash that resets the starting line.

Finally, the Excess CAPE Yield, which compares the inverse of the Shiller CAPE ratio (that is, earnings yield) to the ten-year Treasury yield. It’s one of the few signals that adjusts for the low-rate environment. Currently, with a CAPE of ~33 and ten-year yields above 4.5%, the excess yield is approaching negative territory.

That’s a historically awful setup.

Whenever excess CAPE yield has turned negative, future returns tend to hover at or below the rate of inflation.

The basic logic? If you can get 4.5% with no risk and stocks are offering a real yield of less than 3%, the equity risk premium is functionally zero.

There’s simply no reason to stretch for stocks, unless you’re betting on multiple expansion from already excessive levels. Good luck with that.

Put it all together and here’s the story: the S&P 500 is priced to deliver at best 3–4% nominal returns annually over the next decade, with a decent shot of dipping closer to 1–2% if we get a proper valuation washout. And that’s before factoring in inflation. On a real return basis, you could be looking at flat or even negative returns over the next ten years. That’s not a doomsday forecast.

It’s the historical norm when starting valuations and sentiment are this euphoric.

Could we do better? Sure.

Markets are not math equations, and momentum can keep valuations lofty longer than any sane person would expect.

But betting your money on that outcome is playing chicken with history.

There is an asset class and strategy that can put us on the right side of history and deliver solid returns even if stocks do better than expected: the forgotten workhorses of the capital markets.

I’m talking about the upper tier of the high-yield market, otherwise known as “fallen angels” or “almost junk.” These bonds have a fascinating habit of quietly winning when nobody’s looking.

This has been especially true during equity market “lost decades,” when the S&P 500 spins its wheels and delivers little to no return for years on end. These bonds have consistently proven themselves to be a reliable, even remarkable, source of income and capital appreciation.

Let’s set the historical table. The 1970s and the 2000 to 2010 periods are the two big “lost decades” most investors remember.

During the inflation-ravaged 1970s, high-quality high-yield bonds quietly outperformed both stocks and government bonds, delivering nominal returns in the 8–10% range while equities barely kept pace with inflation.

The S&P 500 returned just under 6% annually in nominal terms, but with inflation averaging over 7%, real returns were negative.

There were also massive drawdowns of 50% of so in the indexes.

By contrast, bonds offering high yields and moderate credit risk provided a steady stream of income that not only kept up with inflation but also offered positive absolute returns.

Unlike lower-rated junk bonds, these bonds avoided the worst default risk while still capturing a significant portion of the excess yield available during a decade marked by rising rates and economic instability.

From 2000 through 2009, the S&P 500 had a total return of -0.9%, a negative return over ten full years, including dividends. The market had to digest the dot-com collapse, the accounting scandals, 9/11, and finally the global financial crisis. It was a brutal stretch for equity investors.

Meanwhile, high-quality high-yield bonds delivered positive annualized returns north of 7%. That’s not just a win. It’s a rout.

These bonds effectively live in the “sweet spot” of the credit spectrum: high enough yield to matter, low enough risk to survive.

Institutional investors who bought high-quality, high-yield bonds and held them to maturity were clipping generous coupons, while stock investors endured a rollercoaster that ultimately went nowhere in real terms.

While long-duration Treasuries got crushed and equities faced P/E compression, high-quality high-yield bonds quietly delivered. If we’re heading into another period of stagflation or a lost decade in stocks, history suggests these bonds could once again be the unsung heroes of portfolio construction.

My favorite way to invest in high-quality high-yield bonds is through individual bonds.

I cut my teeth on credit back in the late 1980s and early 1990s during the wreckage of the Michael Milken and corporate raider era.

Digging through financial statements to find bargains is, as Austin Powers might opine, “My bag, baby.”

However, it is a very hands-on strategy and is not always an easy market for individuals to trade.

My favorite way for most investors to play this lucrative market right now is ETF from Infrastructure Capital Advisors. The firm’s new Capital Bond Income ETF BNDS is high-quality high-yield done right.

Fund manager Jay Hatfield‘s approach to markets and credit is similar to mine.

The portfolio is comprised of bonds that I would cheerfully add to my own.

Hatfield also opportunistically uses an option-writing strategy to enhance income while maintaining upside market exposure by using high-yield ETFs.

The current distribution yield is 8.5%, and many of the issues trade at a significant discount to par value.

If valuation and economic measures prove to be right again, the yield alone will deliver a significant premium to the return of the S&P 500.

The narrowing of the discount as bonds move closer to maturity or prices move higher in response to credit upgrades or fed actions will be a bonus.

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