Buy Stocks Now, Bonds Later

Includes: BRK.B, COP, DPS, JNJ, KO, PEP
by: Tim McAleenan Jr.

I recently read an article by Seeking Alpha contributor John Gerard Lewis titled "Young Investors: Buy Bonds Now, Stocks Later." I have great respect for what Lewis has to say about the relationship between bonds and stocks, but I do not reach the same conclusions as he does. I'd like to point out seven things he mentions about stocks and bonds that I see a bit differently:

1. "But more than a few well-regarded observers think the long-term future is bleak. Economists in a recent Bloomberg survey estimated that mean real gross domestic product will grow by slightly more than 2% annually through 2014."

Is there evidence to suggest that we should give weight to "economists surveyed" when making an investment decision? During the 1973-1974 bear market and the crash of 1987, it seemed that everyone except Munger, Buffett, Ruane, and Neff was claiming that stock investing was dead. Heck, many pension funds at the time eliminated the stock allocation from their portfolios. The "Nifty Fifty" fell from 80x earnings to less than 10x earnings in the early '70s. These troughs were some of the best times to invest in American stock market history. There will always be those among us who predict doom and gloom ahead. Heck, even the revered Value Line survey told investors to sell Coca-Cola (NYSE:KO), Dr. Pepper (NYSE:DPS), Pepsi-Cola (NYSE:PEP) because they feared customers might not allocate a portion of their scant incomes to buying soda in 1973. You can always find someone trying to scare you out of buying a security.

2. "Granted, just 10 holdings aren't optimal for diversification, but it's adequate for someone in his 30s."

It is almost impossible to speak for the diversification needs of other investors. If I'm a 30-year-old who inherits $400,000 to support a wife and three kids, I'm sure going to want to put my portfolio into something more than 10 bonds. Likewise, there are hundreds of Americans who have 99% of their net worth in Berkshire Hathaway (NYSE:BRK.B), and they feel completely diversified. Everyone's needs are different.

3. "But you only get one shot to be young, and if stocks suffer a prolonged period of stagnation when you're, say, 30 years old and finally have some money to invest, you may not be able to enjoy having nearly all of your money growing at the robust rate historically provided by the stock market. If the market returns just 0% - 5% annually during an investor's 30s and 40s, an investor will miss the best opportunity to substantially grow the greatest percentage of his portfolio."

It's narrow minded to think exclusively in terms of price growth. If stocks appreciate at a rate of 5%, is it because earnings are only growing at 5% annually? Or could it be that American business is growing at 8% annually, but the price has not risen to reflect that yet? If it's the latter case, then this is a true blessing for investors -- they can buy more profits at a lower price. That's my kind of sale. Solely speaking in terms of stock price appreciation does not tell the full story -- it is often the earnings growth that will have a greater impact on the long-term investor's fate.

4. "Risk-taking is for the young, and we're trading the risk of little or even negative return for some modest initial diversification risk."

Risk-taking is for everyone. There is no investment that does not come with risk, and it's foolish to think otherwise. Most of us are interested in finding opportunities that offer odds in our favor -- the outsized ability to achieve gains relative to a smaller risk of permanent capital loss. That is the art of investing. Now it's certainly true that the risk of permanent capital loss becomes more of a threat as we age -- a 40% permanent loss will most likely be much worse for an 80-year-old with a million-dollar portfolio than a 20-year-old with a $10,000 portfolio, but permanent capital loss is not the same term as risk-taking.

5. "Now, the average maturity of the portfolio is 25 years, but we're not going to worry about prices being driven down by rising interest rates, because these bonds are to be held to maturity. That's why we're not investing in bond funds -- their holdings have varying maturity dates."

This statement bothers me because it's used in relation to a stock comparison. If you own a long-term bond while interest rates rise, your price will go down. For prudent income investing with dividend growth stocks, the exact opposite is the case. If Johnson & Johnson (NYSE:JNJ) is able to raise its dividend by 7% annually over the next decade, then the price will most likely rise as well -- it's highly unlikely that we'll live in a world where Johnson & Johnson is yielding 10%. When a company raises its dividend for a long period of time, the price will most likely rise. Meanwhile, a bond investor will have to deal with the prices of his bond holdings going down if and when interest rates rise.

6. "Why accept the possibility of 1.5%, when 7% is available? If you're young, lock-in that rate with the money you have today. Sure, it's a long holding period, but, in my opinion, it's a wise move, given today's desultory stock market."

The reason investors would accept the possibility of 1.5% stock returns is because there is greater possibility that stocks will perform better than that over the long-term. Conoco Phillips (NYSE:COP) currently yields 4.83%. Chevron yields 3.5%. If these blue-chip companies maintained the same price over the next 10 years and didn't grow their dividend one bit, they would double or triple this 1.5% possibility based on current dividend policy alone. It's unwise to act as if both 1.5% stock returns and 7-8% bond returns are etched-in-stone determinations about future performance.

As Vanguard Funds founder Jack Bogle noted, the American stock market has historically returned 10% annually. But those 10% average annual gains come with a price of admission: there are some nasty downward swings along the way. To quote Alan Abelson on the 1973-1974 bear market: "Panic set in, widows wept, orphans wailed, and sell orders flooded the market with a mighty rush" (from Roger Lowenstein's "Buffet: The Making Of An American Capitalist"). At that time, the Dow Jones was trading at 775. A year later, it skyrocketed to 1,245. John Templeton was on to something when he said that the most dangerous words in investing are "this time it's different." Trees grow tallest when they're planted during market lows.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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