Stocks got pummeled in 2008 and early 2009. Although most markets have since shown good recovery, the message lingers – stock returns are much more volatile in the short-term and much less dependable over the long-term than most investors were led to believe.
In fact, as 2009 began,
the average annual return from stocks over the entire preceding decade was negative (S&P 500 average annual return -1.36%) – a loss! For the same 10-year period, “no risk” US Treasury Bills provided a 3.16% average annual return. And, long-term Treasurys led them both with a 6.59% return (all figures courtesy of Ibbotson).
Now, as 2009 comes to a close and stocks have rebounded some 60% from their March lows, astute investors are wondering if investing in equities is worth the agony. Why don’t we just cash out what’s left of our stock portfolios and settle for the 3% to 6% returns provided by bills and bonds?
Our answer – we would if they (bills and bonds) could. But, regrettably, the confluence of factors that allowed bonds to provide this level of returns over the last decade, actually the last few decades, is highly unlikely to occur in the coming decade. The environment is more likely to be just the opposite.
It’s different this time . . . really.
The return earned on a bond portfolio consists primarily of the interest payments received on the bonds – the portfolio “yield.” The level of yield is determined by the types and quality of bonds owned in the portfolio, and by market interest rate levels prevailing when the bonds are bought – initially and ongoing as interest payments and proceeds of maturities are reinvested. A much smaller but still important component of a bond portfolio’s return is any change in price of the bonds owned – the “appreciation or depreciation.”
To understand why bonds aren’t likely to provide the level of returns of the last few decades, consider the current state of each of the factors noted above.
1. Beginning market yields – The level of interest rates at the time a bond portfolio is initially assembled is the primary factor in determining a portfolio’s ultimate return, at least through the first several years. And, as this table shows, we’re starting from much lower levels than 10, 20 or 30 years ago.
Interest Rate Levels – United States Federal Reserve
2. Direction of change in market yields – The above table also shows that market rates have been steadily declining. This means yields on existing managed portfolios would have steadily declined as interest payments and proceeds of bond maturities were reinvested at ever-lower rates over this period. Over the last several years, this made bond portfolio returns decline relative to their beginning yield levels. And, with interest rates now virtually at half-century lows, most bond portfolios’ yields should continue to decline until market interest rates begin to rise.
3. Current or ending market yields – Market values of bonds vary to reflect changes in the general level of interest rates. If market rates are generally lower than when a bond portfolio was initially purchased, the bonds’ prices will have gone up, and vice versa. (This might sound backwards, but think of it this way – declines in available yields make bonds bought earlier at higher y
ields more valuable, and vice versa.) So, looking back over the last few decades, bond investors have benefitted greatly from price appreciation as interest rates steadily declined. Going forward, with rates already near zero, such declines are simply not possible (unless our bankers decide to pay borrowers to take their money, which, we suppose, may not be all that unreasonable to expect now that the government is running the banks!).
4. Types of bonds in the portfolio – The final factor influencing bond portfolio returns is the composition of the bonds in the portfolios. Managers can increase yields by investing in lower quality, longer maturity, and more price volatile bonds. In recent months, however, the additional returns to be gained by such increases in risk have shrunk dramatically. And, should such spreads widen again, the bonds could suffer significant price depreciation, more than offsetting the riskier bonds’ initial modestly higher yields.
So, what of stocks?
Even if bonds can’t be expected to do as well as in the past, can stocks be expected to do better?
We think so, based on a similar evaluation of their yield and appreciation prospects. The S&P 500 currently provides a dividend yield (which for most investors is taxed more favorably than interest income) in excess of 2%. Many individual stocks of sound companies provide twice this level of yield or more.
As for appreciation prospects, stocks represent ownership in their underlying economy, and history has shown that as that economy grows, the economic value of stocks generally grows at a similar or greater rate. The 3.5% US GDP growth reported for the third quarter of 2009 may falter in the coming quarters, but should average at least 3% over the next few years. The resulting 5+% theoretical return is twice the current yield of the highest quality bonds.
In regard to valuations, the S&P 500 at 1100 is trading at approximately 15 times current annual earnings of the underlying companies. Said differently, stockholders currently earn back about 1/15th of the cost of the index annually. So, the “earnings yield” of the index is currently 1/15 or 6.7%. And, that’s before any growth in earnings in the years ahead.
To us at CoreStates, these measures qualify stocks as a worthy investment – with this core return expectation in excess of 5%, current earnings return of 6.7%, and good prospects for additional return from increasing earnings and expansion of valuations as the world economy stabilizes and growth resumes its historical patterns. Bonds also have a role in many portfolios, but a reduced role relative to that of the last few decades given their much-reduced future return prospects. 
But, the key to investment success for 21st century investors will be to diversify well beyond these two traditional asset classes, carefully select managers capable of taking both long and short positions, and actively manage allocations among the several asset classes based on relative evaluations of the type summarized here for stocks and bonds. Our 8-Cylinder portfolio engine, SCORE manager evaluation process, and 20/20 Global Vision asset allocation perspectives are designed to provide our clients with exactly these capabilities.
They are the foundation of our overarching commitment to clients – to protect their lifestyles and preserve their legacies throughout their investing lifetimes.
Our favorite allocation as of November 17th, 2009:
Stocks 45% Bonds 25% Cash 5% Real Estate 5% Currency 8% Energy 2% Gold & PM 2% Managed Futures 8%
jewelry, but you’re thinking this probably isn’t how the pros do it. 
the average annual return from stocks over the entire preceding decade was negative (S&P 500 average annual return -1.36%) – a loss! For the same 10-year period, “no risk” US Treasury Bills provided a 3.16% average annual return. And, long-term Treasurys led them both with a 6.59% return (all figures courtesy of Ibbotson).
2. Direction of change in market yields – The above table also shows that market rates have been steadily declining. This means yields on existing managed portfolios would have steadily declined as interest payments and proceeds of bond maturities were reinvested at ever-lower rates over this period. Over the last several years, this made bond portfolio returns decline relative to their beginning yield levels. And, with interest rates now virtually at half-century lows, most bond portfolios’ yields should continue to decline until market interest rates begin to rise.
ields more valuable, and vice versa.) So, looking back over the last few decades, bond investors have benefitted greatly from price appreciation as interest rates steadily declined. Going forward, with rates already near zero, such declines are simply not possible (unless our bankers decide to pay borrowers to take their money, which, we suppose, may not be all that unreasonable to expect now that the government is running the banks!).
But, the key to investment success for 21st century investors will be to diversify well beyond these two traditional asset classes, carefully select managers capable of taking both long and short positions, and actively manage allocations among the several asset classes based on relative evaluations of the type summarized here for stocks and bonds. Our 8-Cylinder portfolio engine, SCORE manager evaluation process, and 20/20 Global Vision asset allocation perspectives are designed to provide our clients with exactly these capabilities. 
