John Mauldin pens a popular weekly email titled Thoughts from the Frontline, and this week he brought up the question of whether stocks outperform bonds in the long run, based on a forthcoming article by Rob Arnott, chairman of Research Affiliates, in the Journal of Indexes. Mauldin was intrigued by the performance of bonds and commented:
“How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009! Even worse, going back 40 years to 1969, the 20-year bond investors still win, although by a marginal amount. And that is with a very bad bond market in the ’70s.”
Stocks aren’t always the best investment, and Mauldin goes on to make a point he frequently repeats and that every investor should keep in mind:
“...the long-run, 20-year returns you will get on your stock portfolios are VERY highly correlated with the valuations of the stock market at the time you invest.”
History is useful for at least two reasons in investing—it tends to rhyme, if not repeat, and it helps us understand where we are today. Where we are is in the midst of a massive bull market in bonds that has seen the yields on 20-year Treasuries fall from 15 percent in 1981 to 3.5 percent this month. Just as stock investors stood at the pinnacle in 2000 and 2007, bond investors are standing at or near the pinnacle. Given the length of time involved, bond prices alone say that we’re much closer to the peak than the trough. We don’t know when the peak will be reached, but we are aided by the fact that bond yields are unlikely to go negative. (Short-term Treasury bond yields briefly went negative in December and March, but that was an anomaly that quickly corrected.)
Bond prices might not drop for a long time if rates remain low; however, they also can’t gain much, because rates are already so low. For instance, iShares Barclays Short Treasury Bond Fund (NYSEARCA:SHV) has a yield to maturity of 0.42 percent as of April 1. At the other end of the yield curve, iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT) reports a 3.67 percent yield to maturity as of the same date.
If bonds are expensive in and of themselves, they are becoming even more so relative to stocks. The S&P 500 yield in March was 3.42 percent, slightly less than the yield on 20-year bonds. iShares S&P 500 Index Fund (NYSEARCA:IVV) reported a 30-day SEC yield of 3.48 percent at the end of February. With every drop in the index and rise in bonds, the argument for bonds over stocks grows weaker, but a reversal could take years.
For instance, many stock investors believed stocks were overvalued in the mid-1990s. Alan Greenspan delivered a speech on December 5, 1996, in which he said:
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
The S&P 500 Index traded at 744.38 on that day, but the peak would not be reached until after a frenzied three-year run that saw the index double. Investors might also recall the case of Jeffrey Vinik. He managed Fidelity Magellan beginning in July 1992 but resigned in May of 1996 because of poor performance. Vinik moved one-third of Fidelity Magellan’s assets into cash and bonds, but a rise in interest rates and the continued bull market left him lagging the index by a wide margin. He was right about the long-term trend, but he was four years early in his move into fixed income. Stocks were overvalued but, at the low in February 2009, still traded 33 percent higher than the end of 1995, not including dividends.
Investors should be wary of making the same mistakes today. “Everyone” knows that Treasury yields must rise, but how long will it take? Japan has experienced low inflation since the 1990s, even as the central bank pumped money into the economy and the government spent billions on stimulus programs. The U.S. central bank and federal government have upped the ante: Bloomberg reporters recently tallied the bailout to $12.8 trillion, close to 100 percent of GDP in 2009. It doesn’t guarantee success, however, and two or three years of negative or extremely slow growth in the economy could keep interest rates level or even push them to new lows. Deflation could eat away at the earnings of corporations and force them to put more money into pension plans. Lower tax revenues and high debt levels may lead to higher taxes and slower economic growth. In sum, even though we may be close to a peak, the bubble could persist for what the average investor would consider a long time.
Many investors still like the idea of shorting U.S. Treasuries, however. One investment guru, Marc Faber, recommended in the annual Barron’s Roundtable buying ProShares UltraShort Barclays 20+ Year Treasury (NYSEARCA:TBT) but said, “It may take two years to work out.” Two years may be the minimum in a Japan scenario, but if the government is truly determined to destroy the U.S. dollar and create inflation, it can do it: FDR set the precedent with gold confiscation and subsequent revaluation of the dollar.
Back to stocks, they could be over- or undervalued after the recent rally. Both bonds and stocks rallied from the early 1980s into the early 2000s. There’s no reason why stocks and bonds couldn’t fall for a decade or more. If interest rates rise due to inflation, and not due to competition for savings, we could have another 1970s scenario of poor returns from both assets. Nonetheless, stocks did rise during the 1970s, just not as fast as inflation. Sitka Pacific examined rolling 10-year S&P 500 returns and noted that there were three other years as bad as this year: 1932, 1939 and 1974. Its research shows that the 1930s’ lows were a combination of price and valuation. Stock prices fell and their earnings fell to match. In 1974, however, prices bottomed while the valuation low wasn’t reached until 1982. High inflation pushed up the earnings of companies, but their stock prices did not fully reflect the increase.
In conclusion, long-term investors must keep price in mind when considering historic returns, and inflation should be the greatest concern. The price you pay today is the one thing over which you exercise total control. Continued low inflation will keep bond prices high and stock prices low, but a return to high inflation could reverse this relationship in short order.