A very interesting chart from Leuthold Group points out that this would be the third time since the 1920s that we have emerged from a period in which bonds have outperformed stocks.
In the periods following this re-emergence from bond superiority, stocks enjoyed massive outperformance. The first of the three periods outlined in the chart, was the 1930s bust, the second was 1949 thru 1955.
Jeremy Siegel, too, offers the following argument in favour of "stocks for the long run," from his recent op-ed in FT.com (worth reading):
A look at history shows that the recent experience is not uncommon and excellent returns are available to those who survive rough patches. Since 1871, the three worst 10-year returns for stocks have ended in the years 1920, 1974 and 1978.
These were followed, respectively, by real, after-inflation stock returns of more than 8 per cent, 13 per cent, and 9 per cent over the next 10 years.
In fact for the 13 10-year periods of negative returns stocks have suffered since 1871, the next 10 years gave investors real returns that averaged more than 10 per cent per year. This return has far exceeded the average 6.66 per cent real return in all 10-year periods, and is twice the return offered by long-term government bonds.
Strong future returns also followed poor returns if one extends the analysis to the worst-performing of all 127 10-year stretches since 1871. Without exception, for each 10-year return that fell in the bottom quartile, the following 10-year period yielded positive real returns and the median return exceeded the long-run average.
Both Leuthold and Siegel make a notable case for the future of stocks, though Leuthold focuses on 5 year periods and Siegel on 10 year periods.
Earlier this year, we featured Robert Arnott's thesis on Bonds for the Very Long Run (Bonds: Reversion Cuts Both Ways); Arnott focuses on the past 40 years:
For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns.
Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways; indeed, those 5 percent excess returns, earned in the auspicious circumstances of rising price-to-earnings ratios and rising bond yields, are a fast-fading memory, to which too many investors cling, in the face of starkly contradictory evidence. Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero.
Bill Gross, PIMCO's Bond King, Chief Card Counter and Handicapper, has been exchanging high-grade corporate bonds for longer-dated government bonds, out of concern for deflation.
Is it possible they are all right? Bonds are forecasting deflation and stocks are forecasting reflation. The track record of the bond market, however, as a forecasting tool has proven to be more accurate historically. Pragmatic Capitalist says:
Bond investors (who tend to have a longer time horizon) are forecasting a long battle with deflation. Equity investors (who tend not to think much farther than one quarter into the future), on the other hand, are putting their money on the line in the hopes that the reflation trade is alive and well.
Unfortunately for equity investors, they have a poor record of forecasting the future when compared to bond investors. There have been 4 famous cases of such bond and stock divergences in the last 20 years. The most famous is the summer of 1987. We all know what occurred then. The other three cases were fall ‘94, summer ‘98 and winter 2000. All three preceded declines in the market. Of all 4 instances, three of them preceded 15% declines in the S&P 500.
The strongest case for equities today seems to rest on the sheer amount of cash sitting on the sidelines; $10-trillion in the US and $1-trillion in Canada. Its a weak argument - investors do not invest simply because they have the cash, and these days investors aren't exactly inspired.
James Bianco, of Bianco Research, however, (via WSJ), is skeptical of this simplistic theme:
"If you look at the mutual-fund flows there is a record amount going into bond funds. Forty-two billion dollars went into bond funds in August, which is an all-time monthly record. In fact, the all-time monthly record, I believe, for stock funds was $55 billion back in February of 2000. So it’s pretty close to the stock-fund record. But when you break it down, what you’ll find is that short-term muni funds, and short-term corporate funds, those are the funds that are getting huge, huge inflows.
The short-term corporate funds are up 12% this year. And as we talk right now, the S&P 500 is up around 16% this year and the Dow is up about 11% this year. That’s including dividends. So my conclusion was, “Yes, there’s a lot of money that’s built up in the cash on the sidelines. Yes, it is going to come out of that zero interest rate funds. And its going into short-term bond funds, which by the way are performing pretty much in line with the stock market. So don’t hold your breath. You’re going to be waiting a long time before you see that money ever matriculate into the stock market.”"
And,
"Now a couple things about that. The first one is I hate when they say, “There’s $3.5 trillion on the sidelines and that’s a whole lot of money.” It implies that all of that money should be put in investments like the stock market. That’s not true. The vast, vast majority is in transactional balances.
It’s money that is going to be needed in a very short period of time, like, within a year. It’s going to be spent on something. They’re almost like checking accounts, if you want to think of it that way. It’s like somebody saying, “You’ve got $10,000 dollars in your checking account, why don’t you $10,000 worth of stocks?” And the answer is, “Well because I’ve got to pay my credit card bill and my rent.”
The strongest case for the bond market is coming out of PIMCO's thesis, which calls for a 'New Normal," a future of De-Leveraging, De-Globalization, and Re-Regulation. The three elements combine as a recipe that ultimately results in stable and stronger dollar outcome as debt repayment repatriates cash from abroad as well as domestically into the credit and bond markets. A strong dollar on this basis results in falling prices, thus the case for deflation.
Bottom line: This may be time to use the equity market's strength to rebalance out of equities in favour of government bond and money market allocations.
