The stock market has a problem: It has underperformed long-term government bonds for 20 years.
Money you invested in the S&P 500 twenty years ago performed no better than long term government bonds, and you certainly would not have slept as well as a bond-holder.
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The End for Bonds
Unfortunately, you cannot just dump your stocks and buy bonds, because the bond gravy train is skidding to a halt.
The Fed, which is short for the Federal Funds rate, is the rate at which banks lend money to each other overnight. The Fed is a barometer for interest rates in general, and it’s been falling for 20 years.
What happens when interest rates fall for 20 years? Two things:
- Americans buy houses they can’t afford, precipitating a global financial crisis
- The value of long term bonds increases for 20 years
A Short, Painless (Optional) Paragraph on Bond Prices
Most people have a sense that bond prices fluctuate with interest rates, but let’s spend 15 seconds simplifying this right now.
- In January of 1990 you loaned $100,000 to the US Government for 30 years at an 8% interest rate. You will receive checks from the Treasury totaling $8000 a year through 2020.
- Interest rates fell, and at the turn of the century new buyers of 30 year bonds earned only 6%, or $6000 a year.
- At that point, your older bonds just increased in value. Here's how: Your $100,000 bond earned you $8000 a year in interest. To get $8000 in interest with a 6% bond, you would have needed to buy $133,000 worth of bonds, because $133,000 X 6% = $8000. By buying before interest rates fell, you saved yourself $33,000 to get the same $8000 in annual interest.
- 30 year bond rates continued their decline, to 4.5% today. Thirty-year bond-holders who bought their bonds 20 years ago will continue to get super-sized 8% payments for 10 more years.
For bond investors, this 20 year decline in interest rates meant that every long term bond they bought paid them interest plus a kicker because the bonds themselves became more valuable as interest rates fell.
The Bottom Line
The bottom line is that bonds did really well for 20 years, but now they will just do average – and average performance does not mint double-digit millionaires. We need stocks to make money, but how?
The Whole Market
The S&P 500 contains only 500 of the 6,400 public, exchange-traded companies in the United States. However, because these 500 companies are so huge, they make up 80% of the value of all 6,400 companies. So when you own the whole market, you really own the S&P 500 with a splash of mid-cap and a sprinkle of small-cap.
This market-cap-weighting phenomenon explains why buying a whole market fund like the Russell 3000 does not improve your returns much above the S&P 500 alone.
In the graph below, you can see that their returns are practically identical.
- Owning the S&P 500 is not very compelling
- Owning the whole market is not much different because the S&P 500 dominates the portfolio
Clearly, if we are going to find stocks compelling, we need to get out the scalpel and starting cutting away at the 6,400 companies that - as a whole – have not beaten long term bonds in 20 years.
As a first cut, let’s look at two portfolios: One that holds only value companies, and one that holds only small companies.
Somewhat frustrating, but these big 50% cuts did not do much for us. This is because the Russell 3000 Value still contains mostly large companies, and the Russell 2000 SmallCap fund contains half growth companies (growth being the opposite of value).
Now let’s try the Russell 2000 Value, which contains only "small/value" companies, meaning companies that are both small and value at the same time.
Take Out the Microscope
With the Russell 2000 Value, we are peering at the value half of the small cap universe, which is just 1,279 companies that together are worth $500 billion out of the $13.8 trillion total US market cap.
By confining our portfolio to this 4% of the whole market, we are finally making progress. Instead of 6X our money, we now have 9X our money. We have earned 11% annually since 1990. Not bad, but look at the graph: We are still below our pre-recession 2007 high water mark, which is a little depressing.
One fund company that I use, Dimensional Funds, goes further into the small/value space, creating quasi-index funds that attempt to capture this small/value premium more effectively than the Russell 2000 Value. The companies in the Russell 2000 Value have a median market cap of $519 million, but the Dimensional fund weighs in lighter, with its companies having a median market cap of $337 million. In other words, there is no trick here: The Dimensional fund is just designed to capture smaller companies, so the returns are higher.
Let’s graph Dimensional’s returns to see how pushing further into small/value may improve upon the Russell 2000 Value.
Now we’re cooking with gas: We have almost 16X our money in 20 years, which is 4 complete doublings, or an effective interest rate of 14% per year. Plus - check the graph - the recession is fully behind us!
Looks like we have found a domestic asset class strategy by cutting away 3/4 of the companies in the stock market.
ETF investors will want to use the following funds to achieve this small/value focus in their portfolios for US equities:
- VBR - Vanguard Small Value ETF. Tracks the MSCI US SmallCap Value Index.
- IWN - iShares Russell 2000 Value Index Fund. This will deliver the same returns as the Russell 2000 Value lines in the graphs above.
Stocks vs. Bonds
The truth is that stocks are very volatile, and even with small/value returns of 16X over 20 years, there is a place for bonds in every portfolio. While younger investors may have only 30% bonds, the average for our wealthier clients is 70% bonds. If you are a pure capitalist with no income other than your investments, then you tend to be more conservative, and you are using equities as a kicker on your overall returns.
Whatever your appetite for stocks, looking to small/value means spending the risk you are willing to take in the right way, and making the most money for every unit of risk you own.
A Word About Time Periods
You can pick other time periods and get different results for the stocks vs long-term bonds comparison, but one thing never changes: Small/value remains consistently superior to both the whole stock market and to bonds.
For example, if you look since January 2000, bonds had 2.3X returns, whereas the S&P 500 was flat at 1.04X (i.e. just 4% up after a whole decade!). Small/value still outperformed long term bonds with the Russell 2000 Value (ETF: IWN) at 2.8X and the MSCI US Small \Cap Value Index (ETF: VBR) at 3.0X.
Jumping from 10 years to 30 years, a whole market investment finally beat bonds, with long term bonds at 17X, the S&P 500 at 28X, and the Russell 2000 Value at 45X.
Conclusion: Let Capitalism Do The Work
You can go back to 1926 and find the same facts: if you naively own a “normal” equity portfolio dominated by large growth companies, you will have dramatically lower returns than if you stay inside of small/value. Most likely you will lose faith in your ability to ever make money in stocks, and you will either migrate to cash over time, or chase casino tactics like market timing and sector investing that will hurt your returns.
The key to superior returns is as simple as it is profitable: own a correctly structured portfolio, and don’t interfere. Capitalism will do the rest.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.