Saturday, March 28, 2009 1 comments ++[ CLICK TO COMMENT ]++

Bonds have outperformed stocks for the last 41 years...but this is not bearish for stocks

Yes, as hard as it may to believe, bonds have supposedly outperformed stocks since 1968. This, according to a short blurb from Barron's [free; scroll to bottom article], which quotes some research by Rob Arnott of Research Affiliates. (Thanks to The Big Picture for bringing the story to my attention.)

(source: Streetwise, Lawrence C. Strauss. March 28, 2009. Barron's)

Before we look into what all this means, I should note that I haven't looked into the details and hence am not sure if this chart is plotting total returns or only price returns. If this chart is price only, I suspect that bonds would still beat total returns of stocks in the recent period but the period would be shorter. So the key conclusion still remains.

The key point the chart is making, and what Rob Arnott is suggesting, is that, stocks may underperform for long periods of time. The chart suggests that stocks underperformed bonds for 70 years in the 1800's, 20 years starting with the Great Depression, and the current 41 year period starting slightly after the stock market hit a major peak in the late 1960's.

Overall stocks have outperformed bonds but if one was living during a period when bonds beat stocks, then it wasn't a great asset to own.

As far as I'm concerned, all this overvaluation/undervaluation is not important if you are a value investor or a contrarian who is attempting to buy cheap assets. If you are stockpicker, your goal is to make money no matter what. The successful ones do make money even if stocks are in a major bear market. The classic example is how Warren Buffett, as well as many other superinvestors, did really well in the 70's even though it was the worst bear market in history if adjusted for inflation. The key thing is to buy something that is fairly cheap.

If, on the other hand, you are a passive investor, I think it definitely matters whether bonds outperform stocks or not. It is also important, in my opinion, for macro-oriented investors and that's one reason I look at these macro market valuations. I think newbies will also probably benefit by looking at these valuations since it gives some notion of whether assets may be overvalued or not.

Price Matters

If one hasn't figured it out by now, they will learn really quickly that, if you are a long term investor or a value-type investor, what matters is price. This is something that all of us sort of know but we never utilize it to any appreciable degree.

Stocks may be the best asset in the long run but sometimes are not. I alluded to this excellent insight from Geoff Gannon (I am sure this is nothing original but he is the first one that really hammered home this point for me):

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap.

This is sort of a key tenet of value investing and is sort of what contrarians try to capitalize on.

This thought can be generalized to every asset out there. Some asset does well at times, not because there is anything special about it, but because it may be extremely cheap. For example, real estate is generally a very good investment. I'm not an expert on it but my understanding is that it outperforms all other assets in the long run, including bonds, commodities, and gold (the only exception is stocks.) This has been the case for almost 100 years (do note that the nature of real estate has changed and there was likely a macro supercycle arising from increased urbanization which boosted real estate in many cities and densely populated provinces/states.) But if you bought real estate two or three years ago, it's doubtful that they will outperform bonds or commodites or maybe even cash for the next decade or more. It is possible that someone who purchased a home in the US 3 or 4 years ago will underperform all other assets for most of their life (I am not saying that real estate will post negative returns; rather, all I'm saying is that it will underperform other assets.)

The valuation concern is one of the reasons I have not really made a long term investment in more than an year. Since my Ambac investment, admittedly a disaster of epic proportions, I haven't purchased any stocks (except for special situations, which are event-based and short to medium term.) Stocks are attractive but I am compelled to wait for them to get really cheap. If they don't get cheap, I'll miss out on some gain but that's ok.

Is That Chart Bearish For Stocks?

Going back to the chart, and the notion of bonds beating stocks for almost 40 years, are we to draw a bearish conclusion for stocks? I would say no!

If you are a contrarian, that chart is actually bullish. It's not extremely bullish--that's why I'm still waiting--but it is getting there. The fact that bonds have outperformed stocks for so long may mean that the cycle is about to turn. Who knows how long it will take but you can basically buy shares that are reasonably valued now--whereas they were richly valued in the last two decades.

Indeed, Jeremy 'stocks for the long run' Siegel is quoted in the article as saying:

...the worst backward-looking stock returns were in July 1932 [and] yet that was the single best time to buy stocks ever, [as they outpaced] ALL other assets over the next five, 10, and 20 years.

This is absolutely true. You were better off buying right after major crashes than at almost any other time. However, I do feel that one should keep the following caveats in mind.

Some Concerns About Stocks

The first thing to note is that it is highly probable that stocks will outperform government bonds (which is what is compared in the chart.) Government bond yields are really low and they will only beat stocks if we get a Great-Depression-style environment or one like the recent Lost Decade in Japan. Even someone like me, who leans more towards deflation than inflation, does not believe that either scenario will unfold. Hence, stocks will likely beat government bonds... What is uncertain is whether stocks will beat the bond market in general, which includes corporate bonds, foreign government bonds, asset-backed securities (ABS), mortgage bonds (MBS), and so on. Corporate bond yields are much higher and so are that of many ABS and MBS. If one was making an asset allocation decision between bonds and stocks, it is worth considering, to some degree, non-government bonds over stocks. I'm just guessing here but, it's possible that non-govt bonds will beat stocks for as long as the next 10 years.

The other concerns have to do with potential macroeconomic shifts. Like most economic issues or macro trends, this is purely speculation on my part so you should form your own opinion.

It is possible that we may see a shift away from stocks and into bonds. Part of this will be due to psychology. Namely, people who get burned may avoid stocks in the future. Already, I see many people off the street--like you and me but not into investing--saying that they won't be directing as much into stocks in the future. I haven't heard many say they were going to liquidate all their investments but many do say that they won't be contributing new savings to stocks. These are just some random cases on television and newspaper so who knows how representative this is of the world. One thing I can say with certainty is that retail investors in Japan have basically been shunning the stock market ever since the crash (supposedly the vast majority of the volume on the Tokyo Stock Exchange in the last decade has been from foreigners.) There is a risk, albeit a small one, that this may occur in America and Canada as well.

Another concern is the possibility of baby boomers, who hold most of the wealth in America and Canada, liquidating stocks to service their retirement. It is possible that many will gradually shift most of their assets from stocks to bonds. Companies that do not pay dividends or are highly volatile may be vulnerable to selling from the baby boomers. Such an action would be bullish for bonds and bearish for stocks, although the degree of impact is not clear.


So to sum up, bonds have supposedly beat stocks for 41 years (not sure if this includes dividends.) I personally do not view that as being bearish; and in fact think it is quite bullish for stocks. However, it is possible that corporate bonds/ABS/mortgage bonds/etc may outperform stocks for the next 10 years. Even if stocks look attractive, they may see liquidation from baby boomers and anyone that was burned by them (especially younger investors who only started investing in the 90's and ended up being clobbered by two crashes: the dot-com crash and now the credit bust.) These parties were net liquidity providers to the market in the last 20 years but may turn out to be a drag for the next twenty.


1 Response to Bonds have outperformed stocks for the last 41 years...but this is not bearish for stocks

April 20, 2013 at 8:27 AM

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