How Long Can Stocks Beat Bonds By A Wide Margin?

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by: James Picerno

Stocks are expected to outperform bonds in the long run, but how much is too much over a medium-term horizon?

The question is topical in the wake of a strong bull market for US equities over the past decade. Although stocks have had a rough ride so far in 2018, recent wobbles haven't dented the decisive performance edge over bonds, at least not yet.

Consider how representative mutual funds stack up over the past 24 years. For stocks, the proxy is Vanguard 500 Index (MUTF:VFINX), an index fund that tracks the S&P 500. For bonds, the proxy is Vanguard Intermediate-Term Investment-Grade (MUTF:VFICX), a portfolio with an average effective maturity of six years that's comprised of US government securities and investment grade corporate bonds.

The chart below tracks how the daily return spread for the two funds has fared through time. The spread is calculated as the cumulative daily return difference for stocks less bonds. A rising spread index indicates that stocks are outperforming bonds; a falling index reflects bonds beating stocks. As you can see, recent history has favored stocks - rather dramatically, in fact. The spread index's current reading is 2.27 as of yesterday's close (June 20) - close to the highest level in nearly 18 years.

In other words, the last time this spread index was this high, the US stock market was in the early stages of an extended bear market. Is a repeat performance underway? Maybe, but maybe not. The chart above can't be used in isolation to make such a call, at least not with any confidence. But the chart does highlight the fact that equities have enjoyed a strong run over bonds for a number of years, which suggests some degree of caution is advisable at this stage.

Analysts can counter that the prospect of rising interest rates will act as a headwind for bonds, and so, fixed-income assets face the possibility of low or negative returns going forward. Fair enough. But keep in mind that the spread index above can fall, because stocks decline more than bonds. That's a reminder that weak or negative bond returns are no guarantee that equities will rally or even hold steady.

For another perspective on the stock-bond horse race, let's turn to rolling five-year annualized returns. In the next chart below, the red line tracks the trailing five-year performance for stocks (VFINX) less bonds (VFICX). Here, too, the numbers show that equities have been outperforming bonds by a wide margin for several years. Indeed, for much of the past five years, the equity edge has been substantial.

The case for thinking that stocks can continue to outperform bonds starts with an upbeat outlook on the economy. As discussed earlier this week, recent numbers suggest that second-quarter GDP growth for the US is accelerating - a solid plus for stocks and more bad news for bonds, since a firmer macro trend will strengthen the Federal Reserve's commitment to raising interest rates, which will weigh on bond prices.

But no matter your outlook on the economy or bonds, the case for a cautious allocation to stocks is reasonable for one simple but powerful reason: all markets are subject to cycles (even if recent history suggests otherwise), and the current bull run for equities is no spring chicken.

None of this means that stocks are due to crash or that bonds are poised to outperform equities anytime soon. But the data above should at least convince investors with an average risk tolerance, give or take, that at this late date in the cycle it's crucial to carefully think through the case for maintaining an aggressive allocation to equities, US equities in particular.

That's another way of asking: What's the case for not rebalancing your portfolio, if only on the margins, after an extraordinary run for US stocks?

To wit, is it really different this time?