The following letter is in response to our article, Bonds for the Long Run? Not Quite Yet, which was published on April 21.
Dear Editor,
I enjoyed your review of Arnott’s article. I, too, have used the 1966-2008 period to show that stocks do not always beat bonds. In a presentation I gave last fall, I used an assumption of rolling over the 5-year every three years; i.e., buy a 5-year Treasury, sell it in three years (as a 2-year) and buy another 5-year. During the three-year holding period, I assumed interest payments were kept cash (a conservative assumption). Simple strategy. I then compared that to a dividend-reinvested S&P500 portfolio. Bonds beat stocks from 1966 to 2008.
But – when I presented those results, I confessed to my audience that I had cherry-picked my periods! You can claim to prove anything if you search the databases hard enough and conveniently leave out evidence contrary to your assertion.
The key to this winning period for bonds was the starting point chosen for stocks. If you pick a starting point for stocks when they are 40+% overvalued (using the Shiller measure of 10-year normalized P/E ratios in my case) and an ending point where they are sitting right at fair value, you have a rather disappointing experience with stocks! You lost 40% of your potential return simply due to stocks returning to fair value. If you are a money manager who is paying attention to expected returns, you should have expected that to happen in 1966 – and not be surprised by it today.
Today, the more relevant question for investors is what holding period to consider when we have a fair-valued starting point for stocks, and compare that to long-term bond yields at low-to-normal levels. For stocks to underperform bonds going forward, you will need to assume that stocks will move below fair value steadily – and stay there for a long, long time. If stocks stay at fair value, they will probably return inflation plus 3.5% or so, like they always have when measured across fair-valued holding periods. Bonds have NOT paid inflation plus 3.5% over long periods of time, and it would be irrational to expect them to this time around.
Cheers,
Rick
Rick Ashburn, CFA
Creekside Partners Investment Counsel
Lafayette, CA
