Stocks or Bonds: The Easy Choice

No one knows what any market will do in the future. But with hundreds of billions of dollars pouring into bonds and 10-year Treasuries yielding 1.5%, it's worth taking a peek at what history says about the past. This quote, from The Economist, seems particularly relevant: "Investors who bought Treasury bonds at a 2% yield in 1945 earned a negative real annual return of 2.3% over the following 35 years."

Investing isn't easy, but the important parts are simple. Buy an asset when it's expensive, and future returns will likely be low. Buy cheap, and you'll probably do all right. There are ups and downs and booms and busts and lost decades throughout, but a basic appreciation of how valuation dictates the future can go a long way. It also shows why bonds produced such dreadful returns after 1945.

In the 1940s, interest rates had been falling for the better part of 20 years as the Great Depression drove knee-jerk risk aversion, and hit record lows as various policies and incentives moved to cheaply finance wartime deficits. According to Yale economist Robert Shiller, 10-year Treasuries yielded 5% in 1920, 3% by 1935, and 2% by the early 1940s. The consensus came to believe low rates were a permanent fixture. "Low Interest Rates for Long Time to Come," read one newspaper headline in 1945.

But as the saying goes, if something can't go on forever, it won't. By 1957, 10-year Treasuries yielded 4%. By 1967, 5%. They breached 8% in 1970, and zoomed to 15% by 1981 as inflation scorched the economy. Since bond prices move in the opposite direction of interest rates, this was devastating to returns. Deutsche Bank has an archive of Treasury returns in real (after inflation) terms, which tells the story:

Period

Average Annual Real Returns, 10-Year Treasuries

1940-1949 (2.5%)
1950-1959 (1.8%)
1960-1969 0.2%
1970-1979 (1.2%)

Source: Deutsche Bank Long Term Asset Return Study.

Don't underappreciate how awful this was. In real terms, $1,000 invested in 10-year Treasuries in 1940 would have been worth $584 by 1979 -- this for an investment often trumpeted as "risk-free."

No one knows if the same performance will be repeated over the coming years. Japan is a good example of extremely low interest rates sticking around for decades. But the risks are obvious. With 10-year Treasuries yielding 1.5%, there is virtually no chance of high returns over the next decade. The odds of being hammered and suffering negative real returns are, however, quite good.

How about stocks? Here, too, no one knows what the future will bring. But history has an opinion.

The same Deutsche Bank study mentioned above shows that, after inflation, stocks produced an average annual return of negative 3.4% a year from 2000 to 2009. That was the third time since 1820 that stocks underwent a decade of negative real returns. Even during the Great Depression years of 1930-1939, stocks squeezed out a positive return.

Something else that sticks out from the study's nearly 200 years of history: Stocks have never produced back-to-back decades of negative real returns. Big booms have invariably followed long slumps. Stocks logged negative real returns during the 1910s, and followed up with blistering 16% real returns in the following decade. Returns went negative again during the 1970s, then shot to nearly 12% a year in the 1980s.

That may just be a quirk of the calendar. What matters are valuations. One of the best ways to measure the overall market's value is Robert Shiller's CAPE ratio, which calculates market price divided by 10 years' average earnings, adjusted for inflation. Its current value is 21, compared with an average of 19 since the S&P 500 began in 1957. So that's a little high. But here is where stocks' long-term superior gains come into play. Since 1880, the average 10-year return after CAPE at current levels is 7.7% a year, or about 5% a year after inflation. That's nothing to write home about, but it's almost certainly better than you'll achieve in bonds these days.

Unlike bonds, there are several good, high-quality stocks with long track records that can be purchased today at prices that set you up to earn decent future returns. A few I like are Procter & Gamble (NYSE: PG  ) , Colgate-Palmolive (NYSE: CL  ) , and Johnson & Johnson (NYSE: JNJ  ) . For more ideas, check out The Motley Fool's special report: "The 3 Dow Stocks Dividend Investors Need." It's free. Just click here.

Fool contributor Morgan Housel owns shares of Procter & Gamble and Johnson & Johnson. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Procter & Gamble and Johnson & Johnson. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 10, 2012, at 5:37 PM, yhtbaotbai wrote:

    The best-performing security inside my portfolio during thepast two years has been my long-term U. S. Treasury strips, like it or not. Thanks to David Rosenberg.

  • Report this Comment On July 10, 2012, at 6:11 PM, StarWitchDoctor wrote:

    yhtbaotbai

    I also see that the TIPS i purchased after QEI have outpaced most, but not all, of my stock purchases at the same time.

    The question at hand now is not what has happened but what will happen. Skate to where the puck will be. That is what makes hockey easy for some and difficult for others.

    Scott

  • Report this Comment On July 10, 2012, at 6:57 PM, oberta wrote:

    It seems that QE3 will not happen and that the interest rate will be kept at nearly zero. So bonds investment will be the choice.

  • Report this Comment On July 10, 2012, at 7:08 PM, Educationist wrote:

    Can any one tell me the best bonds to buy? American group I had is very good; but are there any other bonds blue chip that is worth buying. I do have very good stocks: Colgate (CL) 500 shares that I bought 15 years ago; KO I bought in 1980 (300 shares ) but today the Borad of Directors have announced split 3 for 1 . I also have Exxon Mobil 700 shares bought 240 shares but later split in 2001 and then has grown since then. Any advice Motley fools?

  • Report this Comment On July 11, 2012, at 9:09 AM, mikecart1 wrote:

    My bonds are doing marvelous right now. People want to make moves wayyyy before anything actually happens. Bonds will remain like this at least through the elections. That is 5+ months of making mad money baby!

  • Report this Comment On July 11, 2012, at 4:07 PM, anbcooper wrote:

    I'm always perplexed by these types of articles. The author seems to imply that the main reason to own bonds is income and/or the attempt to outperform stocks. It doesn't address the root reasons why many investors keep bonds in their portfolio and it doesn't address a key component of bond investing which is duration.

    So, here is my layman's attempt to address this.

    1. Bonds are negatively correlated to stocks, this negative correlation smoothes out your portfolio returns and reduces volatility. Many investors enjoy reduced volatility and therefore include bonds in their portfolio.

    2. Keeping bond durations short to mid-term - 2 to 5 years allows maturing bonds to be replaced with higher interest rate bonds in a rising interest rate environment. This article focused on 10 year treasuries, which are riskier in an ultra low interest rate enviornment such as today.

    The goal for most of us to maximize total portfolio return. Intermediate and short term bonds fit into balanced portfolio to do this.

    Do I think bonds will outperform stocks over the next 30 year? Absolutly not, but I do think that the inclusion of bonds into a portfolio will reduce its volatility and keep money ready for rebalancing when the next downturn in equities comes.

    It appears the author ignores this fact and only wants to use the performance of 10 year bonds to equities in historically low interest rate environments as a reason to not own any bonds. I think the issue is more complex than that.

  • Report this Comment On July 14, 2012, at 10:20 AM, SkepikI wrote:

    The only way bonds will "smooth out" your portfolio if you hang on to them long term (what they are supposed to be) is by acting like an anchor on your returns, with a vicious rabbit punch at the point interest rates start back up. That rabbit punch will be the decline in value as rates increase. When will this happen? Nobody knows. But the odds of bonds increasing in price further from 1-2% interest is pretty low. How do I know? simple math. $1000 bond earning 2% gives you 20 bucks a year. Who bothers to take price decline risk on 1000 for 20 bucks a year. Who cares when I can put that same 1000 in a solid business with innovative and useful products (I could name 10 here but wont) for that same return?

    AND some people think at worst you will get your money back when the bond matures...not always true! Just ask former GM or Enron or a hundred other corp bond owners from past bankruptcies. Yes you can avoid this by Treasury bonds, but you still face price decline risk from arbitrary policy decisions. Not a pretty picture. Not much room for more declines in rates, so not much room for the price increases bonds have enjoyed.

    AND if you never sell, you never collect on price increases, you just ride out going from 2% to 1%, get less income and kick yourself for not selling at the top. Pretty grim future from here. I wouldn't be saying that if we were at 4 or even 3% at least you get paid a little better and there is room for appreciation.

    If you were lucky or smart enough to buy years ago, with coupon rates above 4%, then you still get your return on original investment at that rate, until the investment matures. If you are in a fund, not so. But either proposition is better than buying new now at these rates. Ergo, at some point soon, bond buyers will revolt and quit buying. No I dont know when, but I dont need to, I just need to know it will happen and wait for it. What do I lose? Well, the difference between .1% and 2% or so, which means I am out about 19 bucks a year on 1000. I can afford that to stay away from those decline risks that I know will happen someday. (soon I think, 2 years or less)

  • Report this Comment On July 14, 2012, at 5:12 PM, aleax wrote:

    @Educationist, my favorite bonds right now are "junk" ones and (especially) selected municipals. I insist on keeping at least 25% of my securities portfolio in fixed income ones (the rest is in common stocks, MLPs, REITs, ...) but that doesn't mean I have to settle for 1.5% on US Treasuries -- or negative on German Bunds!-).

    There's a lot of fear around, which makes for great pricing on well-selected junk bonds and munis (just as it makes for lousy pricing on Treasuries, Bunds and UK gilts, somehow all perceived as "safe havens";-). Munis' pricing is also "helped" by big scary headlines about bankruptcies such as Stockton's and San Bernardino's (here in California, where I prefer to pick my munis to avoid the State's crazy high income taxes).

    Picking and choosing the right junk bonds and the right munis is quite a specialized skill, but good actively managed (NOT indexed!-) mutual funds and ETFs can do the heavy lifting for you -- relatively high expense/fee ratios compared to index followers, to be sure, but, results justify that (e.g compare HYLD vs JNK's on both yield and capital results YTD...).

    HYLD is my personal pick for junk bonds (in my 401k of course); for munis I usually prefer to pick and choose myself, but when I want liquidity and/or to keep just a small amount in munis (in my taxable account of course) I've found PWZ pretty decent (alas, no actively managed CA-munis ETF that I know of (FICAX is OK if you'd rather have a normal mutual fund than an ETF -- I prefer ETFs myself).

  • Report this Comment On July 14, 2012, at 5:30 PM, ChrisBern wrote:

    Why quote Shiller's P/E average only back to 1957? Shiller easily retrofitted it to date back to the 1880s, and the average is 16.43. If you only date back to 1957, it heavily overweights the anomaly that is post-1990 valuations, which historically speaking are WAY higher than normal. Furthermore, in the EXACT same paragraph, you talk about a different stock which you choose to take back to the 1880s. No offense but it seems like the data was cherry-picked a bit.

    Regardless, even with the 1957+ average, stocks are overvalued right now as you mentioned. This isn't even taking into account the fact that most of the world's PMI is below 50 and the world is almost surely entering into a global slowdown and probably recession. What was the average PE10 in the past under today's stagnant circumstances? Significantly lower than today's 21.3, I'm sure...probably about 10 if I had to guess.

  • Report this Comment On July 16, 2012, at 11:08 AM, TMFMorgan wrote:

    <<Why quote Shiller's P/E average only back to 1957? Shiller easily retrofitted it to date back to the 1880s, and the average is 16.43.>>

    Because the S&P 500 index began in 1957. Shiller attempted to recreate the index back to the 1880s, but there are flaws that make it somewhat apples-to-oranges. Nearly all publicly traded companies in the late 1800s were banks or railroads. It's hard to compare those PEs to today's index, made up of technology, consumer, and multinationals.

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