Stocks vs. bonds: Is it no contest?
The bond market has a serious PR problem: Nobody seems to believe there’s much appeal in those securities.
And that’s helping the stock market win more fans -- because if there’s little or no attraction in bonds, the crown in that beauty contest often goes to stocks by default.
This should be of more than passing interest to baby boomer investors in particular. Somewhere between ages 50 and 60, investors typically are counseled to begin tilting their portfolios more toward bonds and away from stocks, to protect their capital.
Buy bonds today?
Why would you, when one of the smartest players in that market -- Bill Gross of Pacific Investment Management Co. in Newport Beach -- is holding 43% of the assets in his huge Pimco Total Return bond mutual fund in short-term money market instruments rather than in bonds?
That’s certainly not a ringing vote of confidence in longer-term fixed-income securities.
Nor was a report last week from investment research firm Morningstar Inc., headlined “Just How Safe Is the Bond Market?” The conclusion was that investors who were used to thinking of bonds as a safe place to be ought to steel themselves for a potentially bumpy ride this year -- for example, if the housing market’s woes cause more nervousness about mortgage-backed securities.
Anyone who has shopped for bonds recently can relate to the discomfort that Gross and Morningstar have with them. Bonds just don’t pay much. Although the Federal Reserve has sharply raised short-term interest rates since 2003, longer-term rates haven’t come up a lot since then.
The annualized interest yield on a 10-year Treasury note was 4.67% on Friday. The average corporate junk bond pays barely 7% a year.
Plenty has been written about why long-term interest rates are depressed. In the end, it must come down to too much money chasing too few bonds, worldwide.
Whatever the cause, if this is the hand you’re dealt, what do you do with it?
Many Wall Street pros say you pass for now. You can earn nearly 4.9%, annualized, in a money market mutual fund, with virtually no risk to your principal. No wonder Bill Gross has so much of his bond fund in those cash accounts.
If you’re looking to put money to work for the next decade or longer, some financial advisors suggest that you focus on stocks instead of bonds, even if retirement is on the horizon.
Wait a minute, you may be thinking. Aren’t stocks far riskier than bonds?
Generally, that’s true. U.S. blue-chip stocks dropped nearly 50% from their peak in 2000 to the market’s bottom in 2002. Odds are that you’re never going to suffer that kind of real or paper loss in high-quality bonds.
In the short term, anything could trip up stocks: Iran’s nuclear ambitions, another jump in oil prices, a hedge fund blowup, a wayward asteroid headed for Earth.
So bonds do play a capital-preservation role in a portfolio, and no one would advise that older investors give up on them altogether.
But there’s another kind of risk -- the risk of losing purchasing power to inflation if your portfolio doesn’t grow fast enough over time.
David Kelly, an economist at Putnam Investments in Boston, believes that many investors have become overly risk averse about stocks since the 2000-02 bear market. “People are haunted by that ghost,” he said.
One result, he contends, is that too many people now “overpay for bonds and underpay for stocks.”
In other words, investors are willing to accept lousy yields on bonds because they fear that stocks are too expensive to buy.
Yet the average U.S. blue-chip stock sells for 16.6 times estimated 2006 operating earnings per share, according to Standard & Poor’s. That is not much above the historical average price-to-earnings ratio (since 1935), and is well below the P/E ratio of 22 that was the average over the last decade.
Averages can mislead, of course. Still, it’s a common refrain of money managers today that they find the U.S. stock market to be priced just about right -- neither expensive nor cheap compared with underlying earnings.
By contrast, it’s hard to find a professional investor who doesn’t believe that bonds are expensive.
Even if you think that both stocks and bonds have become pricey (that’s Bill Gross’ view), the issue in picking investments always is one of relative value.
“Our internal valuation models suggest that equities are relatively cheaper than bonds,” said Ken Taubes, head of fixed-income investing at Pioneer Investment Management in Boston. That’s tough for a bond man to concede, he says, but he accepts the verdict.
Ed Keon, investment strategist at Prudential Equity Group in New York, says the surge in corporate takeovers by private equity investors over the last few years demonstrates that bonds should be sold and stocks should be bought.
That’s what those investors are doing, he notes: They’re borrowing via bonds to buy stocks.
In the stock market, “the lack of buying by the public has created opportunities for the private equity buyer,” Keon said.
One reason private equity buyers are so confident (besides their innate hubris) is that they believe there’s little chance of recession anytime soon. That’s the Federal Reserve’s opinion as well. The Fed expects a slowdown for a few quarters, but nothing more serious.
If that forecast is wrong, and a recession looms in 2008, a year from now stock prices may be sharply lower, anticipating a plunge in corporate earnings.
That’s one scenario that could benefit high-quality bonds: If investors begin to fear economic trouble, many would rush for perceived safety. That could drive bond prices up and their yields even lower, at least in the case of top-quality IOUs such as Treasuries. Locking in today’s yields would look smart in retrospect.
But if the economy is going to be OK, or better, in the next few years (a replay of the late 1980s and late 1990s), bond investors have to wonder how much lower long-term interest rates can go -- or whether they’re more likely to rise than to fall or stay level.
At the same time, a prolonged economic expansion is exactly what stock market bulls are hoping for, because that also should mean prolonged growth in corporate earnings, which underpin share prices.
If bond yields do rise, they’ll become more appealing for new investment dollars and offer more competition for stocks.
Until then, if all you can earn on a bond is a fixed 5% or less in annual interest over the next 10 years, it isn’t asking a lot of the stock market to beat that return.
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Stocks vs. bonds, the last 10 years
Can stocks beat bonds over the next decade? They did over the last decade, despite the deep bear market of 2000-02 and even though bonds paid higher yields (compared with current yields) for much of that period.
Mutual fund average annualized total returns, 10 years ended Dec. 31
Average foreign stock fund: 8.80%
Average U.S. stock fund: 8.18%
Average long-term bond fund: 5.39%
Note: Total returns are price change plus interest or dividend income.
Source: Lipper Inc.