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, Random Roger (151 clicks)
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"Can Stocks Be Safer than Bonds?" Felix Salmon explores this idea in a post and concludes probably not. I would submit that the way the question is posed and addressed are actually framed incorrectly. If we start by proclaiming that bonds are safer than stocks then you'd probably get a lot of shrugs of acceptance. Invoking Karl Popper; it only take one result to refute the theory. I don't think I would get too much push back if I proclaimed that a client holding Johnson & Johnson (NYSE:JNJ) is safer than two year Greek sovereign debt.

Depending on where you look in the bond market you will find issues that are both "safer" and "less safe" than equities. Similarly, depending on where you look in the equity market you will find issues that are both "safer" and "less safe" than bonds.

Once an investor moves past the building block level of learning about investing, the word safe simply becomes the wrong word. Volatility might be a better way to think of it but even that may not be sufficient.

Investors, as opposed to traders, hope for different things from equities versus bonds. With equities investors want to see a combination of price appreciation, dividends and dividend growth with the realization that the trade off should be some amount of risk and volatility. With bonds most investors are looking for a steady interest payment and little to no price volatility. Hopefully the unvolatile bonds will provide some ballast against the "normal" volatility of equities. The ability of a company to make its interest payments will not reasonably be affected if the company earns $0.71 versus an expectation of $0.74 although such a report might hit the equity price very hard.

We know that equities can be either attractively priced or unattractively priced (or fairly priced too). If a bond is unattractively priced at the moment then it should be expected to have more threat of risk or more correctly volatility than something that is attractively priced. Consider a corporate bond due in ten years. If, as a simplistic example, ten year treasury yields are close to all time lows (which they are) and the spread of that corporate bond over the ten year is historically low then the bond is not attractively priced; it is relatively high in price.

This particular bond may stay expensive for a long time or not but it is still expensive, a buyer is buying high. The consequence for this would be a large price decline in the bond if rates go up thus creating volatility in the portfolio. Yes the investor gets his money back at maturity but large price declines tend to cause people to panic sell.

The contrast can be buying equities when they are cheap or thought of differently, after they have gone down a lot. Equities that are already down a lot might go down more of course but the risk of further declines decreases the more the market drops.

Buying something that is expensive is not universally bad as anything that is now expensive can become more expensive and it works the same way with things that are now cheap getting cheaper. Buying a US ten year treasury a few months ago with a 3.4% yield was buying high based in historical standards but turned into a pretty good trade when yields went to 2.9% a week or two ago - but I'm not sure it could be considered safe.

Part of Felix' post was a response to a reader who appeared to be making the case for dividend stocks as a proxy for bonds. The argument has never made a lick of sense to me. That JNJ might yield more than a US treasury is not an argument for one over the other even if it is an argument for JNJ to be cheap or for treasuries to be expensive. They have different characteristics and should deliver different things to a diversified portfolio. Echoing a point that Felix made, if JNJ has some sort of problem far worse than what has happened over the last year and the dividend is cut I have no doubt the stock would go dwarf star with no guarantee of a return to the high watermark. If interest rates go from 3% to 6% over night then a ten year note would probably drop about 25% in price - simply creating the likelihood of investors having to wait until maturity to get back the investment, but they would get it back in nominal terms.

Source: 'Can Stocks Be Safer Than Bonds?'