Last month, we published our first of two articles in this series, "The Treasury Run". In our first article, we illustrated the dramatic run we have witnessed in U.S. Treasury Bond prices since the year 2000. In the second part of this article, we are going to expand on these points and put them into a much broader historical perspective. You see, many investors have a tendency to formulate their opinions and expectations of the markets based on the time period during which they have been investing, but over longer periods of time, we see inflection points in the markets - inflection points where long-term trends reverse course and we move towards a reversion to the mean.
The dramatic run we have witnessed since 2000 in U.S. Treasury Bond prices, and more specifically the relative outperformance of bonds versus stocks over this time period, has happened before. From the onset of the Great Depression in October of 1929 until December 31, 1941, U.S. Treasuries went on a similar run.
(Note: In our previous article we cited the Barclays U.S. Treasury 20+ Year Index as our proxy for historical U.S. Treasury Bond prices. Unfortunately, we are unable to retrieve historical data on this index dating as far back as the 1920's. Therefore, in the context of this discussion we have utilized the Ibbotson & Associates SBBI U.S. Long Term Government Bond Index as our proxy for U.S. Treasury Bond prices.)
The Great Depression: 10/1/1929 - 12/31/1941
It goes without saying that the time period starting with October 1st, 1929 until December 31st, 1941 will long be remembered as the worst and certainly most volatile time period in U.S. stock market history. During this period, the S&P 500 incurred a maximum drawdown of a gut-wrenching -82.58%! While certainly not the focus of this article, the volatility during this period was also unparalleled; consider that despite the tremendous losses incurred by equity investors during the Great Depression, in July and August of 1932 the S&P 500 TR Index was up greater than +38% in back to back months! (Morningstar)
Nevertheless, getting back to our point, this period marks the last time (prior to what we have experienced in U.S. markets since 2000) that U.S. Treasury Bond prices dramatically outperformed U.S. stocks. During this period the S&P 500 TR Index averaged an annual rate of return of -4.44%; conversely the IA SBBI U.S. Long Term Government Bond Index averaged an annual rate of return of +4.99%. In other words, the performance spread between stocks and bonds was an average of 9.43% per year. (Reference Figure 1)
From the Tech Bubble, to the Great Recession, and Beyond: 1/1/2000 - 12/31/2012
We focused on this time period in our last article, but suffice to say the relative outperformance of bonds versus stocks looks eerily similar to that which was last experienced during the Great Depression. From January 1st, 2000 up until the end of last year, the S&P 500 TR Index averaged an annual return of +1.66%; the IA SBBI U.S. Long Term Government Bond Index averaged +8.99%. This implies a performance spread of +7.33% between these two asset classes, in favor of bonds! (Reference Figure 2)
Where this gets interesting, and may perhaps foreshadow what lies ahead for investors, is what happened the last time we saw this happen.
The Bear Market in Bonds: 1/1/1942 - 12/31/1981
What happened after the last time we saw U.S. Treasury Bonds dramatically outperform stocks for more than a decade was truly amazing. January 1st of 1942 marked the beginning of a long and painful (for conservative investors and savers) 40 year bear market in bonds. Over the course of the next 40 years, the S&P 500 TR Index would average an impressive annual rate of return of +11.70%; versus a paltry +2.28% over this same time period for the IA SBBI U.S. Long Term Government Bond Index. While on the surface, this may not sound wildly dramatic, when you consider the compounding effect on returns over four decades the impact was astounding. Over this 40 year time frame the cumulative return on stocks was +8,254.38%, versus a cumulative return on bonds of only 146.51%. Put another way, had an individual invested $100,000.00 into the S&P 500, after forty years their balance would be $8,354,385.00. The same investor placing $100,000.00 in the IA SBBI U.S. Long Term Government Bond Index would have been left with a balance of $246,513.90. (Reference Figure 3)
What followed this forty year time period was equally impressive, and I believe puts into perspective comments from such fixed income luminaries as PIMCO's Bill Gross, that our thirty-year bull market in bonds is over.
The Bull Market in Bonds: 1/1/1982 - 12/31/2012
After scarcely generating even a modicum of returns for long term investors for forty years, bonds went on a run one might have to question if we will ever see again. From January 1st, 1982 until the end of last year, the IA SBBI U.S. Long Term Bond Index averaged nearly the same average annual return as the S&P 500 TR Index; with an average annual return of +10.77% versus +11.14%. (Reference Figure 4)
Certainly it doesn't take a market historian, technician, or guru to tell you that an average annualized return on long term U.S. Treasury Bonds of nearly 11% is unsustainable. Frankly, it was more of a function of our environment over the past thirty years; one that will largely be remembered by fixed income investors as possessing a gradual decline in interest rates. Obviously this provided a favorable backdrop for bonds, but what does all of this mean for the future of fixed income?
I leave the answer to that question to those with far greater wisdom than myself. It is not in our inherent nature to attempt to predict future prices, the future state of our economy, etc. Quite the contrary, we adhere to a trend following approach; taking advantage of trends that are already in place. Over both shorter and longer term cycles there are underlying currents in the investment markets. We simply aim to participate in them, whether they are in favor of risk assets (stocks), or in assets that have historically provided investors with a margin of safety (U.S. Treasury Bonds).
What I will leave you with is this…
A Time Tested Relationship
Throughout the history of the capital markets, whether bonds have been in the midst of a prolonged bull or bear market, they have always served as a safe haven for capital preservation when equities have experienced a prolonged decline. (Reference Figure 5)
This inverse relationship, demonstrated time and time again, lends support to investors participating in tactical investment strategies, with the ability to rotate portfolio holdings among asset classes. However, for long term buy and hold investors in fixed income, the months and years ahead may prove to be more difficult.