What’s an investor to do?  In the wake of the painful losses we’ve experienced over the past 18-months, well-known market gurus seem to be sending conflicting messages. 

On one side are those who, focusing on their potential for higher returns, continue to advocate holding a significant portion of your portfolio in equities; on the other, are those who point out that stocks are too risky -- even over the long-term -- and prescribe an asset allocation heavily weighted toward bonds.

Part of the disagreement depends upon the time frames and methodologies used in the analysis.  There’s also the question of just how useful historic returns are in forecasting future returns. 

The chart below comes from the financial research firm Ibbotson Associates, founded by Roger Ibbotson.  It’s included in a research paper co-authored by Ibbotson and Peng Chen, PhD. entitled “Are Bonds Going to Outperform Stocks Over the Long Run?”

 At first glance, the answer to the “stocks-vs.-bonds” question seems like a no-brainer: over the past one, five, 10 and even 20 years, both intermediate as well as long-term government bonds have soundly beaten the return on the S&P 500 Index, which consists of large-cap U.S. stocks.

Even over longer periods such as the past 30 and 40 years, the total return on bonds has been surprisingly similar to that of equities.  Why would you even think of owning stocks -- with all of their inherent Maalox Moments -- when you can get similar or better returns from safe, predictable fixed income investments that are backed by the U.S. government?

Despite the above results -- or perhaps because of them -- the paper cautions that the relative out-performance of bonds is something “one should view… with skepticism.”  Chen argues that bond returns of the recent past are not likely to be repeated in the near future.

The reason has to do with the low interest rates government bonds are currently paying and the likelihood of higher inflation in the coming years.

Chen suggests looking at the last 40 years -- the period running from April 1969 through March of this year.  Over that time, the annualized return on long-term government bonds was nearly identical to that of the S&P 500 Index: 8.79% versus 8.70%.

But Chen points out that much of that can be attributed to the 1970s and early 1980s, when both inflation and the interest rates on bonds were in double-digit territory.

Inflation, as measured by the Consumer Price Index, hit 12.3% in 1974, fell back to single digits through 1979, then hit 13.3% in 1979 and 12.5% in 1980.  The next year, in order to entice investors the U.S. Treasury had to offer 13.5% on its Intermediate bonds.  The coupon rate on long-term treasuries hit 13.4% in 1982. 

Then the Federal Reserve’s inflation-busting moves began to take hold.  In 1983, inflation was “only” 8.9%.  As inflation continued to decline, so did the rate at which individuals were willing to loan the government money.  Since the price of a bond moves in the opposite direction of interest rates, investors who had bought bonds just a few years earlier got something they had never seen before: huge capital gains in the prices of the securities they held.

“The [return that the] government bond produced came off a high coupon yield and high appreciation.  [These conditions] are probably not going to be there going forward,” says Chen. 

By comparison, at the end of March, the yield on intermediate-term Treasurys was just 1.68% and the yield on long-term government bonds was 3.55%.  Not only are investors today receiving much less interest, there also isn’t much room for rates to decline.   As a result, bond buyers cannot count on the kind of the capital gains they’ve enjoyed over the past 40 years.

As Chen and Ibbotson calculate it, “for bonds to continue to enjoy the same amount of capital gains over the next 40 years, a rough estimation would put the yield into negative territory…  This is simply impossible, because it implies that investors would be willing to lend their money to a borrower(1) and pay the borrower an interest rate.

Not only is it unlikely that bond investors will see much -- if anything -- in the way of capital gains going forward, Chen asserts that a more likely scenario is that they will experience capital losses.

Just as bonds increase in value when interest rates fall, the opposite is true:  when interest rates rise, bonds prices decline.  In light of the ever-widening federal deficit, Chen thinks the interest rates on treasury securities will inevitably increase. “If you have a lot of debt, your creditworthiness is going to decline.  Investors will demand [a higher] interest rate to continue to lend money.”

Another factor is the enormous amount cash being poured into the world economy.  “Given the amount of liquidity from central banks, inflation will go higher and could lead to higher interest rates.”

Even if bond yields were to remain where they are today, Ibbotson and Chen write that “that means the total returns for bond investments would likely be between 2% to 3%.”  Not even close to the returns we’ve seen over various periods during the past 40 years.

In their research paper, Ibbotson and Chen point out that, historically, the growth in U.S. equity earnings has been around 5%, roughly in line with the growth in the economy.  “If we assume the market valuation level (operating P/E of S&P 500) stays at the same level over the next 40 years, then we would have an equity return of around 7%.”

If they’re correct, stocks should provide twice the return of bonds. 

While predicting that stocks in general will out-perform bonds over the long-term, Chen advises diversifying beyond the United States and Europe.  “I expect that emerging markets could do better than developed markets.”  The reason is that emerging markets did not get as tangled in the sub-prime mess.  As a result, their balance sheets are healthier. 

“Especially Asia,” says Chen.  “The governments have a good amount of reserves, financial companies did not get into toxic assets and did not have the write-downs, and most consumers have high savings rates.”

In contrast, he points out that “the U.S. government has a huge amount of deficit spending.  On the corporate side, companies, especially financials, are damaged.”

Let’s face it: last year’s stock market performance was gut-wrenching.  The return on the S&P 500 was a negative 38%, the second worst on record.  (The worst year, and not by much, was 1931 when the market lost more than 40%.)

Chen says he and Ibbotson decided to publish their paper because they were concerned about investors cashing out their stocks and pouring money into treasury bonds and money market funds.  As Chen describes it, there was “a rush into ‘safe’ assets, especially during the fourth quarter of 2008 and the first quarter of this year.” 

Behavioral finance, which studies the psychology behind investment decisions, has shown that we tend to make long-term decisions based on short-term conditions.  We assume that whatever is happening in the market today -- be it good or bad -- is not going to change. (Think tech stocks in the late 1990s, residential real estate prices just a couple of years ago, high interest rates of the ‘70s and ‘80s, the Depression, tulip bulbs in the 1600s, for just a few examples.) 

When things do turn around, it generally happens quickly.  Most investors are surprised -- and unprepared.

“We felt that people were probably doing the wrong thing at the wrong time again,” explains Chen.

Chen and Ibbotson wanted to put things into a longer term perspective.  The conclusion of their research is that “long-term history provides two major insights:”

    1. Stocks have outperformed bonds.

    2. Stock returns are far more volatile than bond returns, thus more risky.  Given the additional amount of risk, it is not surprising that stocks don’t outperform bonds every period -- even over extended periods of time.

Nonetheless, according to Chen, individual investors should not abandon equities.  “If you have a short [time] horizon and need the money, you shouldn’t be in stocks in the first place.  If [you have] more than three years, you should consider stocks.  Over time they tend to produce a higher return.” 

 1) In the case of Treasury bonds, the “borrower” is the U.S. government.