In the latest issue of Forbes, a cover story recommends shunning stocks and buying corporate bonds. In The Case for Bonds, author Bernard Condon writes:
Want to avoid getting burned buying into the latest asset bubble? History suggests shunning stocks and buying corporate bonds.
Smooth out earnings by looking at the long-term P/E, which captures a decade's worth of inflation-adjusted data, and the market is trading at a multiple of 16. That's right around its average over the past 130 years and suggests stocks are reasonable but hardly cheap. Reasonable, that is, as long as you have faith that corporate America will soon resume the earnings power it had over the past decade.
Corporate bonds look like better values than either Treasurys or equities…the yield spread has narrowed to 3.1 percentage points.
Analysis & Commentary
Corporate bonds are a better deal than treasuries because, currently, almost any asset class is cheaper than treasuries. However, the author fails to convince me that I should shun stocks and buy corporate bonds.
What Goes Down, Must Come Up
According to today’s article in the Wall Street Journal, due to a ballooning deficit and future inflation, the party for treasury bonds is over.
As interest rates go down, bond prices go up. The primary driver for recent bull market in bonds was the decline in interest rates from 1982-2009. In 1982, bond yields were at their peak, over the next 27 years bond yields declined and bond prices rose as inflation was kept in check. Early in 2009, we reached the bottom of the mountain, as real interest rates were at their lowest point in many decades, well below their historical averages. Reversion to the mean applies: what goes down, must come up. 10-year Treasuries are currently yielding 3.31% and 30-years are yielding 4.20%.
The 40% Solution
On a risk-adjusted basis, lower volatility bonds, have been the winner over stocks over the past four decades. Since bonds and stocks have performed equally well over the past four decades, a 60:40 stock-bond mix has delivered higher risk-adjusted returns than a 100% stock portfolio. This is because over the past four decades, the total return of 20-year bonds has surpassed stocks, as the above chart from Rob Arnott's provocative article shows.
The Inflation Factor
As the above chart shows, prior to the early 30s, the US experienced alternating cycles of deflation and inflation. The U.S. government moved to cushion the effects of the Great Depression by raising the official price of an ounce of gold from $20 to $35, effectively devaluing the dollar. Since then, deflation has been replaced by persistent inflation.
Persistent inflation is devastating to bonds. Unlike stocks, bond investors rarely fully recover from a period of high unexpected inflation.
How Long Is Long Term?
While bonds have performed well over the last four decades, stocks have trounced bonds over the past century. As Arnott’s chart shows, over the past two centuries, the stock market’s cumulative return has been 100 times that of bonds.
In a recent article, Jeremy Siegel documents the long and devastating bear markets in which bonds had negative returns after inflation:
For the 55-year period from December 1925, when the well-known Ibbotson stock and bond series begins, through January 1982, total real government bond returns were negative. This means that, by rolling over in long-term government bonds, reinvesting all the coupons, and thereby taking no income, investors' bond portfolios were sinking in value.
Most strikingly, for the 40-year period from 1941 through 1981, government bond investors lost a whopping 62 percent of their value after inflation. A loss in purchasing power over this long a period has never happened in stocks. There has never even been a 20-year period when real returns in stocks have been negative. In fact, the worst 30-year real return for stocks is plus 2.6 percent per year, just slightly below the average real return investors earn with government bonds.
Continuing, Siegel states that government bonds are overpriced, and face a dismal future:
… Bonds have admittedly done extraordinarily well over the past four decades. Over that time, long-term Treasuries have returned nearly 12 percent per year before inflation, and the returns on stocks ending at the bottom of the bear market in March of this year were just a few basis points lower.
But 40 years ago treasury bonds were yielding over 6.3 percent, about twice their yield today. It is mathematically impossible for government bonds to come close to matching those 12 percent returns in future decades. Stocks, on the contrary, can easily repeat their returns over the past four decades, since those returns were near their historical average.
It is a mistake to use recent performance as a basis for investment decisions. True asset class performance is shown over long periods such as Siegel’s data since 1871 or Dimson, Marsh & Staunton’s 100 year data.
Bonds ARE An Important Asset Class
Classical portfolio theory recommends that to minimize volatility, the average investor should put 60% of his portfolio in stocks and 40% in bonds, because no asset class can diversify a stock portfolio as well as bonds. However, an asset class that has negative real returns over many decades is worthless. You can’t eat diversification.
According to Siegel, the worst 30-year real return for stocks has been 2.6%/year, therefore an investor with 30 years until retirement should heavily weight in stocks. Bonds are useful for the investor with a shorter time horizon, in which case corporate bonds are probably a good bet for income investors. Those not needing current income should consider inflation-protected bonds such as US or Foreign TIPS.
Several other asset classes can be used to diversify a US Stock portfolio. While none diversify as well as bonds, all provide a high degree of diversification:
- Foreign, Developed Market Stocks.
- Battered REITS, are promising but risky. Pending defaults on CMBSes indicate that this sector may have more room to fall.
- Emerging Markets Stocks.
- Stocks of Commodities Producers.
FULL DISCLOSURE: Long VNQ, U.S. Equities, Non-U.S. Equities, Emerging Markets Equities, US TIPS and WIP. You should perform your own due diligence and consult with an investment advisor before investing.