Time to Forsake Stocks for Bonds? Arnott and Arends Square Off

We still can't feel as sanguine about our near- and medium-term economic prospects as traders (and the few remaining investors) appear to these days, but there's a powerful logic to "don't fight the tape"--let alone the Fed. Whatever the market's near-term prospects, when one takes a longer, multi-year view, this strikes us as a probabilistically attractive time to acquire equities.*

Two items caught our attention along these lines: Rob Arnott's much-discussed Index Universe piece on the relative performance of stocks and bonds in recent years. (We mentioned Arnott's research earlier this month.) As we argued in March, true bottoms tend to be marked by mass indifference, even revulsion toward stocks. In turn, one would expect that indifference to manifest itself in grinding, low-volume trading. But intelligent, sensible efforts like Arnott's can flash revulsion as well, not of the rash, emotional sort, but a kind of mean-reverting phenomenon in which the data Arnott cites, backward-looking by definition, are unlikely to repeat themselves. Take a look at Brett Arends' excellent coverage of this issue in Tuesday's Wall Street Journal:

"Starting any time we choose from 1979 through 2008," Mr Arnott writes, "the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor." He argues the figures are even true going back to the late 1960s.

Mr. Arnott's article has generated quite a stir in the investment world, where he has, in theory, turned a lot of received wisdom on its head.

But American mutual fund investors, responding to last year's turmoil, are already voting this way with their wallets. So far this year they've withdrawn $45 billion from mutual funds that invest in the stock market, and put $68 billion into bond funds, reports the Investment Company Institute.

Should you follow suit? Not so fast.

Obviously bonds, especially Treasurys, held up well during last year's crisis. And they can make an important part of a portfolio, especially at the right price. But anyone hoping for a repeat of the last thirty years is probably dreaming.

The second item that leaped off the screen at us was yesterday's Journal story on financial advisers forsaking traditional buy-and-hold strategies rooted in asset allocation and Modern Portfolio Theory. We manage money in two styles, one traditional and strategic, the other (mildly) alternative and tactical. But we've been doing that since before the crisis, and when we see media coverage of rank-and-file advisors (and, implicitly, their clients) throwing up their hands in disgust at the supposed failure of traditional methods of portfolio construction, we can't help but think that this is a great time to have (or acquire) an inexpensive, diversified portfolio of global asset classes. To return, in other words, to the methods many people (professionals included!) can no longer abide. That's our kind of revulsion.

~~~~~~~~~~~~~~~~
* Which, as always, implies no particular guesses about the short-term direction of the market.

Sources

Rob Arnott, "Bonds: Why Bother?" Index Universe, April 27, 2009

Brett Arends, "Bonds' 30-year Hot Streak Begins to Cool," Wall Street Journal, April 28, 2009

Anne Tergesen and Jane J. Kim, "Advisers Ditch 'Buy and Hold' for New Tactics," Wall Street Journal, April 29, 2009

Comments

[Larry House:]

No argument here with a diversified, world allocation. I am using PGMDX for that. I do think we are entering a time period, perhaps a decade, perhaps less, where a ladder portfolio of corporate bonds may very well beat equities and reduce risk as well. Part of the portfolio should mature each year to take advantage (if it is an advantage) of current interest rates. I prefer that approach, bonds held to maturity, over a bond fund.

Apr 30 03:05 PM

[Steve in TN:]

I wish the sale of bonds were deregulated like equities have been for years. The commission rates for bond are just too high for me to buy individual securities over bond funds. So currently I'm stuck with LQD, AGG, and BND.

Apr 30 03:27 PM

[Mad Hedge F...:]

Good place to take some trading profits. The whir of the printing presses again spooked the bond market, taking ten year Treasury bond yields up to 3.14%, and the 30 year to 4.10%, a one year high. This is going to be a recurring event over the next several years, and a short in long term Treasury bonds should be a core position in any portfolio. My favorite play here, the Power Shares Lehman 20+ ETF (TBT), a 200% short play on the sector, has been on an absolute tear, up 40% since January. We are early days into this trade, and once inflation hits, the TBT could see a spike to $200 in its lifetime.

Apr 30 03:29 PM

[PearlCreek:]

I would hardly call 15% of the sample population "revulsion", nor would I particularly describe the article describing the strategies that those financial guru's in the WSJ journal are fleeing to as MPT. I suspect 90% of the financial professionals couldn't adequately describe MPT much less construct a portfolio based on MPT.

I would probably describe it more as butt covering and trying to keep clients.

Apr 30 08:47 PM

[mahoney:]

Mad Hedge Fund,

I'm also taking a hard look at TBT, but my worry is that the Fed is going to keep buying up Treasuries as part of their quantitative easing strategy. Wouldn't that keep the Treasury bond prices high (at the expense of the US dollar)? Does anyone have any thoughts on this?

May 01 02:16 AM

[skwestorange:]

The Treasury funding needs are so high - read multi-trillion. The Fed has to keep buying the long end to keep the ten-year rates and vis-vis mortgage rates down. Even if one assumes that the long end accounts only for 30% of the trillions coming down the pike over the next year or two, I don't see how the Fed can keep buying.

May 01 07:06 AM

[LKofScotland:]

Treasury funding needs are high? Feed the pig (and this ain't no add for HSBC)! We long ago reached our limits on Federal spending. As has often been said of New York, however, nothing succeeds like excess. Oil and natural gas plays have had tremendous recoveries from the panic bottoms in the MARKETPLACE. Pre-collapse had financials and their dependents dominating the S&P. Now the dependencies have gone bankrupt or been taken over by the Feds (even worse) and the bankers are in the soup lines. Energy and commodity plays are running the place--let your winners run. This crisis which does not appear as of yet to have truly spilled outside of the financial sector and its minions appears still has many more pounds of sinful flesh to claim. In the meantime for all you goody-two shoes types its time to play tempest in a tea-pot.

May 01 10:11 AM

[shootpar2001:]

You could try Vanguard; the mark-ups are in-line with large (100)
purchases.
Or try higher yielding funds - (ACG), (PTY).

Disclosurers: (ACG), (PTY).



On Apr 30 03:27 PM Steve in TN wrote:

> I wish the sale of bonds were deregulated like equities have been
> for years. The commission rates for bond are just too high for me
> to buy individual securities over bond funds. So currently I'm stuck
> with LQD, AGG, and BND.

May 01 11:48 AM

[Suzanne H.:]

Agree with PearlCreek's comment:
" I suspect 90% of the financial professionals couldn't adequately describe MPT much less construct a portfolio based on MPT"

That is a sad reality, but an even sadder reality is MPT is not adequate without having access to uncorrelated asset classes in all market conditions, and that would require being able to short the asset class or invest in an inverse ETF. The markets last year served as a brutal reminder that proper diversification is what is needed, not trying to guess what worked in the past to deduce what will work in the future. Furthermore, having a portfolio of long only assets, which under normal market conditions don't correlate, will correlate when markets are stressed (and 2008 was not rare in that respect). The only protection is having the ability to switch to neutral or the inverse of whatever asset class is in the portfolio, based on a tactical strategy. With that in place, then the portfolio will be well-equipped to handle anything the market throws at it.

May 01 12:57 PM

[Old Trader:]

mahoney,

I know its said "don't mess with the Fed", but as deep as their pockets are, they don't have NEARLY enough money if the rest of the world develops a distaste/aversion to US debt.


On May 01 02:16 AM mahoney wrote:

> Mad Hedge Fund,
>
> I'm also taking a hard look at TBT, but my worry is that the Fed
> is going to keep buying up Treasuries as part of their quantitative
> easing strategy. Wouldn't that keep the Treasury bond prices high
> (at the expense of the US dollar)? Does anyone have any thoughts
> on this?

May 01 05:51 PM

[Suzanne H.:]

Very possibly true that anyone waiting for the next 30 years for bonds to outperform can be disillusioned (again with a tactical approach, one lets the market show it's hand first because there are never any absolutes). However, my concern for the short term is based on Barron's Big Money Poll in this week's edition where almost 60% of the portfolio managers are bullish on equities and 84% are bearish on Treasuries, and there are more bulls on real estate than bonds. Anybody care to guess the short term outcome of this (hint, it is the opposite of the majority polled, but again let the market show its hand and position accordingly).

May 01 07:14 PM

[jackie.mccoy:]

the shares belonged to my great grand father we can not find the bankers hatton,morris & co bankers

May 08 01:35 PM