WHEN the Dow Jones industrial average climbed back to 10,000 this month, the achievement was widely noted but barely celebrated, and for good reason.
“Haven’t we done this several times before?” asked Edward Yardeni, the economist and investment strategist.
In fact, we had. The Dow had crossed 10,000 on more than 20 occasions, starting in late March 1999, when the market was so hot that stock-picking seemed to have become the national pastime. In that year, the book “Dow 36,000” confidently declared that stocks were “actually less risky than bonds” and that the Dow would more than triple in value within a few short years.
As investors know all too well, the financial history of the last decade turned out a bit differently. Stocks proved to be extremely risky. Despite the recent rally, in the 10 years through September, most stock investors lost money.
What may be less widely understood is that over that same 10 years, while the stock market’s overall returns were disappointing, the bond market produced handsome gains. Bond rallies have not generated the hoopla that the stock market customarily receives, but over the last 10 years, investors have had more reason to celebrate if they held bonds, not stocks, in their portfolios.
Calculations performed for Sunday Business by Morningstar, using data from its Ibbotson Associates subsidiary, show that the stock market underperformed important bond categories over the 10 years through September — with an annualized loss of 0.2 percent for the Standard & Poor’s 500-stock index, versus annualized gains of 8.1 percent for long-term government bonds and of 7.8 percent for long-term corporate bonds.
What’s more, the S.& P. 500 underperformed long-term government and long-term corporate bonds over the last 20 years as well. Over longer periods — 30 years, 40 years, and in an 83-year stretch from 1926 to 2009 — the Ibbotson numbers indicate that stocks did outperform bonds, sometimes by more than three percentage points, annualized. But bonds were far less volatile throughout. And the further back in history you go, the less directly comparable is the data.
Writing in the May-June issue of the “Journal of Indexes,” Robert Arnott, chief executive of the investment firm Research Affiliates in Newport Beach, Calif., declared that bonds had been neglected by the financial press and by many investors. He reviewed market returns going back 207 years, and found that stocks outperformed bonds by only 2.5 percentage points, annualized. This “2.5 percentage point advantage over two centuries compounds mightily over time,” he said. But for very long stretches, bonds have done better than stocks.
The wild ride of the last decade or so does not mean that stocks will underperform bonds in the months or years ahead. If only it were that simple.
For one thing, past returns never provide a clear guide for the future — especially when technology, innovation and government policies are changing the structure of financial markets and transforming the global economy as rapidly as they are right now.
For another, it can be argued that the recent stretch of relative stock market weakness and bond market strength is precisely why stocks are likely to do better than bonds. Jeremy J. Siegel, a finance professor at the Wharton School of the University of Pennsylvania and the author of “Stocks for the Long Run,” advocates stock holdings for people with long horizons but acknowledges that some periods have been painful for equities.
He says that the environment is auspicious again. “Historically, whenever you’ve had long periods when bonds outperform stocks, that sets up an excellent time to invest in stocks,” he said. “So looking forward, things look very favorable for stocks and not favorable for bonds, certainly not Treasury bonds.”
In part because of market intervention by the Federal Reserve, yields on long-term Treasury bonds remain extremely low, and prices, which move in the opposite direction, are high. When and if the economy recovers, bond yields are likely to rise and prices are likely to fall. Low yields, meanwhile, make it cheaper for many companies to finance their operations, which could help generate outsize profits.
Laszlo Birinyi, president of Birinyi Associates, a stock market research firm in Westport, Conn., who says he believes that we are in the middle of a vigorous bull market for stocks, has studied the long-term returns of many asset classes. He has found that from 1970 to 2008, emerging-market stocks outperformed the S.& P. 500, the bond market and alternative assets like oil, gold, real estate and diamonds.
But Mr. Birinyi recommends sticking mainly with domestic stocks and bonds, perhaps adding a sprinkling of foreign stocks that “don’t replicate your domestic stock holdings.”
“My issue with diversification beyond that,” Mr. Birinyi said, “is that an incremental or arithmetic increase in the number of decisions you make leads to a geometric increase in the degree of difficulty.”
The logic for treating domestic stocks and bonds as the two central asset classes was outlined in the 1930s by Benjamin Graham and David Dodd, the fathers of value investing. In their classic work, “Security Analysis,” they emphasized safety — favoring bonds, and only those of the highest quality, as far more suitable for small investors than stocks, which attracted “speculators.”
Because shares of common stock are much riskier than bonds, they need to have the potential for a much higher return to induce investors to hold them, Mr. Graham and Mr. Dodd said. But they wouldn’t have been surprised by long stretches of bond market outperformance.
Read Full Article »