Equities vs. bonds

As the last vestiges of a rather cold winter come to an end, I wonder if the chilling price drops in equity markets may at long last be ready for recovery.

At the end of February 2009, the S&P 500 index was 50% below where it was in March 2000. Since then, March came in looking bearish and left like a bull (if you’ll forgive my mangling a metaphor). By the end of April 2009, major equity markets had already recovered about 30% from their lows of March 9 when the S&P 500 reached apocalyptic lows of 666.

So, is this rally the start of the long road back or the proverbial dead-cat bounce we’ve experienced so often before?

Essentially, the basic underlying principle of markets is: The longer a trend exists with no change (and no apparent risk), the greater the volatility when that trend finally ends (as we have seen in almost all asset classes—especially housing).

MINSKY MOMENT? Let’s examine historical data and explore how economist Hyman Minsky’s concept—long periods of stability in asset classes eventually lead to instability— applies to the trends, volatility and cycles of the stock market, and what that may indicate for us going forward.

Many asset allocation models suggest equities outperform bonds by as much as 5% per year over long periods of time (see “Stocks for the long run?” this page). A 200-year analysis shows the actual difference is half that, or 2.5% per year. That is the equity premium.

There can, however, be long periods of time when bonds (U.S. Treasury bonds) outperform equities.

While many investors are aware this occurred during the Great Depression and the Second World War, most would be surprised to learn that bonds also outperformed equities between 1968 and 2009. (So for the last 41 years, bonds have been the better investment.)

This does not mean equities performed poorly (in fact, $10,000 invested in the S&P 500 in 1968 is now worth $253,000 for an annualized return of 8.38%); bonds generated the same return over the last 40 years or so.

Looked at over a 200-year period, equities provide an average risk premium of about 2.5% above bonds. Since they have provided no return over bonds for the last 41 years, there is a reasonable chance they could provide a considerably better result as we go forward.

During the first 14 years of this analysis, interest rates were steadily rising (from 1968 to 1982), and bonds performed poorly (see “Bulls vs. bears,” this page). But since then, bond rates (for U.S. government bonds) have dropped from about 18% to 2%, making these last 27 years the longest ever bull market in bonds.

Since bond rates are now very low, this bull market cannot be repeated, but it would be reversed if rates rise in the future. Given the amount of fiscal stimulus and liquidity governments around the world are injecting into financial institutions, it might be reasonable to assume the next trend in interest rates will be upward.

GLASS HALF FULL OR HALF EMPTY? It might be depressing for equity investors to realize that since the 1960s they have done no better than a decent bond portfolio.

If equities had averaged 2.5% more than bonds for the last 41 years, the $10,000 we mentioned earlier would now be worth $855,000 versus the $253,000 it is actually worth.

That suggests a very good chance of mean reversion—equities could now outperform bonds by more than 2.5% per year for the next 41 years.

In this case, the Minsky moment that may have ended is related to bonds, not equities.

For the 13 years between 1965 and 1978, the S&P 500 was range-bound and there was no change in the price of the index. However, the markets were volatile with bull rallies of as much as 75% and bear market corrections of up to 45%.

In the end, if you did not get dividends, this is what you saw: › very little cash flow; › extreme, stomachchurning markets; › loss of capital after about 50% inflation; and › markets that did not gain good traction until 1982 when the recession of 1981/82 ended and interest rates started to decline.

The nadir of this long secular bear market occurred in 1974. From that point until 1982, the S&P 500 rose more than 200%, and profits included a combination of both capital gains and dividends.

VALUE INVESTING Today’s equity levels have at least some resemblance to the despair of equity markets in 1974. However, to invest at the bottom of a market in a severe recession takes a level of confidence most investors don’t possess.

Besides, it’s much easier to be right about the longer term than the next six months. In this environment, equities could quite easily fall further.

If your investing time frame is five to 10 years or longer, you will be well rewarded as long as your choice in equities includes dividend-paying companies with strong balance sheets.

Some factors that contribute to successful investing include:

1 .Buying assets that are below their intrinsic value; 2. Buying assets that have underperformed for an extended period of time; 3. Buying assets in recessions or depressions; 4. Keeping leverage low and manageable; 5. Buying assets that generate strong cash flows; and 6. Being prepared to be a continuous purchaser over time in markets such as these (dollar cost averaging).

Markets may be volatile, but as history shows, that tends to be the norm and not the exception. This recession is likely going to last longer than most think and we could easily retest the market lows we saw late last year and early this year. While the recession may last a while longer, I believe it is time to begin steadily acquiring quality assets.

I think the end of this Minsky moment is getting closer.

John Nicola is founding partner and financial planner at Nicola Wealth Management. jnicola@nicolawealth.com