A recent article by Rob Arnott of Research Affiliates called “Bonds? Why Bother?” published in the Journal of Indexes shows how the risk premium of stocks over bonds (20 year treasuries) is not the accepted 5% but rather 2.5%. He writes, “Over this full 207-year span (1802-2009), the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5% trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical.”
As the chart below shows, at current market levels bonds even outperformed equities the last 40 years—so much for stocks for the long run!
As John Mauldin points out in his book Bulls Eye Investing stock performance depends almost entirely on when you buy in and how long your holding period is. Logically, if you buy closer to a peak and sell closer to a bottom your returns will be much lower, possibly even negative. In his book, Mauldin stresses the importance of assessing market valuations for asset allocations.
I disagree with this article in its assertion that “Mr. Arnott’s article is shocking stuff!” Arnott’s research cannot be considered especially surprising considering the definition of a risk premium. Increased reward naturally correlates with greater risk, whether short-term or long-term. Statistically, it makes perfect sense. But is the increased risk of stocks worth the extra 2.5%? Arnott’s chart above clearly shows that for the last 20 years and even 40 years this was not the case.
However, at the same time, Mauldin’s principle of stock valuations and timing applies to bonds as well. Bonds only outperform stocks if one sells stocks and buys bonds at a very precise moment in time. Bonds may have outperformed equities 1929-1949; however, buying bonds only four years earlier would have earned a lesser return than stocks even through the entire Great Depression. For example, buying bonds instead of equities at current market prices is a terrible idea (remember with bonds I mean 20-year treasuries). Not only are bond yields low but with loose monetary policy and excessive debt, inflation is a significant risk.
If there is anything the chart above shows it is not the superiority of bonds but the predictable boom-bust gyrations of equities caused by what Keynes called our “animal spirits.” If an investor can avoid buying equities for the long-term when the market is clearly brimming with irrational exuberance then stocks should outperform bonds. A good indicator of this is the fear index at marketpsych.com. In general, I would not buy equities while this fear indicator is at its low.
This adds a new dimension to "be greedy when others are fearful."
