Tuesday, November 1, 2011

Ducks On A Pond vs. Sitting Ducks?

Between 1926 and the end of 2010, the S&P 500 stock index produced an annualized return of 9.9% per year. Long term goverment bonds only returned 4.4% per year over that period.

Between 1802 and 2010, U.S. stocks generated a 7.9% annual return vs. 5.1% for long-term government bonds.

In the 30 years ending September 30, 2011, the S&P 500 has returned 10.8% per year.  This is better than the historical long-term average for stocks.  However, long-term bonds have averaged 11.5% over the last three decades.  That is over double the historical averages.  It is also the first time since the Civil War that bonds have outperformed stocks over a 30 year time period.

What are we to make of all of this?  First, the last 30 years have been an unprecedented period to accumulate wealth through investing.  It did not really matter how you allocated your money between stocks and bonds.  If you put money aside 30 years ago-you ended up much better than investors have done historically over that timeframe.  It was like shooting sitting ducks on a pond.  No matter where you aimed you were likely to hit something that produced rewards.

How did this occur?  If you go back to October 1, 1981, 30 year treasury bonds yielded 15.19%.  The yield was 2.92% on the 30 year bond as of September 30, 2011.   That has been one heck of a great ride for bond investors.  As you know, bond prices increase as yields decrease.  On the other hand, the S&P 500 Index was a mere 116 in the Fall of 1981.  30 years later it was over 1,100-a 10-fold increase.  It is hard to argue with those results if you just woke up after a 30 year slumber.

However, for those of you who have lived through the last decade the view looks much different. Early in 2000, the S&P 500 stood at over 1,500.  This meant that an investor had actually been able to multiply their money over 13x in less than 20 years between 1981 and 2000.  Of course, the last 11 years has seen the S&P stock investor actually lose money.  In investing timing is everything!  Your view of the world is much different if you invested in 2001 vs. 1981.

What conclusions can we draw from this for the future?  The profit you make from any investment is more dependent on the purchase price than the sales price.  If you buy right, it is hard to not come out right.  In 1981 stocks had done almost nothing for well over a decade.  Stocks were selling at pretty much the same level that they were at in the late 1960's.  At the same time, interest rates increased to unprecedented levels as the Federal Reserve tried to wring inflation out of the system.  Stocks were due for a rebound.  Interest rates looked like they had no where to go but down.  Of course, all of this is crystal clear in hindsight.  It was a little murkier if you had money to invest at that time, as I did.  Who said that interest rates might not go to 20%?  And if interest rates kept going up that was a prescription for much lower stock prices as more money would inevitably be attracted to the higher yields and less volatility in bond investments.

If you apply those lessons to today you have to believe that interest rates cannot go much lower. In addition, how can anyone feel confident about investing in a long term Treasury bond with that small yield when you consider the massive federal budget deficit. 

Stocks have also stagnated for over a decade.  Aren't they due for a rebound?  If inflation does heat up aren't you better with a stock that provides a hedge on inflation rather than a bond that leaves you totally exposed to eroding your purchasing power?  We have also just had the first 30 year period in 150 years that stocks underperformed bonds.  Stocks must be a buy. These are all logical responses to where we are today.

However, between 1803 and 1871-a period of 68 years- bonds outperformed stocks.  That is over twice as long as the period of bond outperformance we have just experienced.  In addition, since 1900,
the stock markets of four major countries have seen investors lose all of their money.  Russian investors were wiped out after the Bolshevik Revolution and the same result occurred to the Chinese, Argentinians and Egyptians.  The Germans were almost totally wiped out twice and the Japanese once due to starting and losing wars.  Helpful investment advice--Beware Wars, Revolutions, Communist and Totalitarian regimes.  They are hazardous to your health and wealth.

Where does this leave us?  I think we are in the most challenging investment period of my lifetime.  There are no easy answers anywhere.  I have tremendous confidence in the ingenuity, imagination and instincts of human beings.  The human capital is there for tremendous advances in productivity and prosperity over the next several decades.  However, so much is dependent on getting the right political and policy framework to make it happen.  We have got to solve the fundamental issues of government in this country.  This is the wild card.  The people will progress if they are allowed to.  However, history has shown that too often government gets in the way.  If we allow that in this country we are all sitting ducks with our money.  Let's hope we can learn some lessons from Europe and get our fiscal and political house in order soon.

In the meantime, do not put all your eggs in any basket.  That is a lesson no one should ever ignore.

Credit to Rob Arnott in the Fundamental Index Newsletter for the data in this blog article.

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