I’m hearing a lot of folks these days draw attention to the fact that the dividend yield on the S&P 500 (2.17%) is now greater than the yield on the 10-year treasury note (1.7%). In doing so, they are obviously making the case that stocks are undervalued relative to bonds.

There are a few problems with this line of thought. First, just because the dividend yield is currently higher than the 10-year treasury yield doesn’t mean stocks will necessarily outperform risk-free treasury notes going forward. If you hold that treasury note to maturity you know exactly what you’re going to get over that time. The same can’t be said for owning stocks which carry far more risk.

To get an idea of what to expect from stocks, you need to study valuations. Personally, I like to use the Buffett Indicator (market cap-to-GDP) because it’s about 90% negatively correlated to 10-year future returns. History shows that the higher starting valuations are the lower your future returns will be and vice versa. This has been true regardless of where interest rates have been or where they are going.

Right now valuations, based upon this measure, suggest the total return from owning stocks is likely to be less than the risk-free return on 10-year treasury notes. So why, you might ask, should you take far more risk in owning stocks when you are likely to do better in risk-free treasuries? Good question.

Some might say that high valuations today are justified by low interest rates. And this is really the case folks are making when they compare the dividend yield in owning stocks to the interest rate on the 10-year treasury note. Well, there are a few guys plenty smarter than I am that have demonstrated why this is such a, ‘dumb idea.’ I would mainly direct you to Cliff Asness’ now classic treatise on the subject, “Fight the Fed Model.”

To boil it down to the simplest argument, Cliff shows that low interest rates imply low future inflation and concomitant low earnings growth. High valuations in equities, on the other hand, imply high future growth. Thus, the idea that low interest rates, which imply low growth, somehow justify high valuations, which are completely dependent upon on high-growth, is faulty, at best.