Investors, we are told, demand a risk premium for investing in stocks rather than bonds.
Without that extra return, why invest in risky stocks if you can get guaranteed
returns in bonds? This week we look at a brilliantly done paper examining
whether or not investors have gotten better returns from stocks over the really
long run and not just the last ten years, when stocks have wandered in the
wilderness. This will not sit well with the buy and hope crowd, but the data is
what the data is. Then we look at how bulls are spinning bad news into good and,
if we have time, look at how you should analyze GDP numbers. Are we really down
6%? (Short answer: no.) It should make for a very interesting letter.
And for the last time, let me remind you of the Richard Russell Tribute Dinner this
Saturday, April 4 in San Diego. We have had over 400 of Richard’s fans (I guess
you could say we are all groupies) sign up. A significant number of my fellow
writers and publishers have committed to attend. It is going to be an
investment-writer, Richard-reader, star-studded event. You are going to be able
to rub shoulders with some very famous analysts and writers. If you are a
fellow writer, you should make plans to attend or send me a note that I can put
in the tribute book we are preparing for Richard. And feel free to mention this
event in your letter as well. We want to make this night a special event for
Richard and his family of readers and friends. So, if you haven’t, go ahead and
log on to https://www.johnmauldin.com/russell-tribute.html
and sign up today. The room will be full, so don’t procrastinate. I wouldn’t
want any of you to miss out on this tribute. I look forward to sharing the
evening with all of you. I am really looking forward to that evening.
Why Bother With Bonds?
If stocks outperform bonds by as much as 5% over the long run then, for our truly
long-term money, why should we bother with bonds? Why not just ignore the
volatility and collect the increased risk premium from stocks? That is the
message of those who believe in “Stocks for the Long Run” and also from those
who want you to invest in their long-only mutual fund or managed account
program. Indeed, it is always a good day to buy their fund.
One of my favorite analysts is my really good friend Rob Arnott. Rob is Chairman of
Research Affiliates, out of Newport Beach, California, a research house which
is responsible for the Fundamental Indexes which are breaking out everywhere (and
which I have written about in past letters), as well as the only outside
manager that PIMCO uses, for his asset allocation abilities. He has won so many
industry awards and honors that I won’t take the time to mention them. In
short, Rob is brilliant.
He recently sent me a research paper that will be published next month in the Journal of Indexes, entitled “Bonds: Why Bother?” The publisher of the journal, Jim Wiandt, has graciously allowed me to review it for you prior to it actually being sent out. The entire article will
be available when the Journal of Indexes
goes to print in late April, at www.journalofindexes.com.
Qualified financial professionals can also get a free
subscription there to pick up the print copy. There is some very interesting
research at the website. But let’s look at a small portion of the essay. I am
reducing 17 pages down to a few, so there is a lot more meat than I can cover
here, but I will try and hit a few things that really struck me.
It is written into our investment truisms that investors expect their stock
investments to outpace their bond investments over really long periods of time.
Rob notes, and I confirm, that there are many places where investors are told
that stocks have about a 5% risk premium over bonds.
By “risk premium,” we mean the forward-looking expected returns of stocks over
bonds. As noted above, if you do not think stocks will outperform bonds by some
reasonable margin, then you should invest in bonds. That “reasonable margin” is
called the risk premium, about which there is some considerable and heated
Most people would consider 40 years to be the “long run.” So, it is rather
disconcerting, or shocking as Rob puts it, to find that not only have stocks
not outperformed bonds for the last 40 plus years, but there has actually been
a small negative risk premium.
In a footnote, Rob gets off a great shot, pointing out that the 5% risk premium
seen in a lot of sales pitches is at best unreliable and is probably little
more than an urban legend of the finance community.
How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year
treasuries, rolling them over every year, beats the S&P 500 through January
2009! Even worse, going back 40 years to 1969, the 20-year bond investors still
win, although by a marginal amount. And that is with a very bad bond market in
Let’s go back to the really long run. Starting in 1802, we find that stocks have beat
bonds by about 2.5%, which, compounding over two centuries, is a huge
differential. But there were some periods just like the recent past where
stocks did in fact not beat bonds.
Look at the following chart. It shows the cumulative relative performance of stocks
over bonds for the last 207 years. What it shows is that early in the 19
century there was a period of 68 years where bonds outperformed stocks, another
similar 20-year period corresponding with the Great Depression, and then the
recent episode of 1968-2009.
In fact, note that stocks only
marginally beat bonds for over 90 years in the 19 century.
(Remember, this is not a graph of stock returns, but of how well stocks did or
did not do against bonds. A chart of actual stock returns looks much, much
Bill Bernstein notes that in the last century, from 1901-2000, stocks rose 9.89%
before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57%
after inflation, giving a real yield difference of almost 5%. In the 19
century the real (inflation-adjusted) difference between stocks and bonds was
only about 1.5%.
In the late ’90s, stock bulls would point out that there was no 30-year period where stocks did not beat bonds in the 20 century. The 19 century for them was meaningless,
as the stock market then was small, and we were now in a modern world.
But what we had was a stock market bubble, just like in 1929, which convinced people of the superiority of stocks. And then we had the crash. Also, from 1932 to 2000 stocks beat bonds rather
handily, again convincing investors that stocks were almost riskless compared
to bonds. But in the aftermath of the bubble, yields on stocks dropped to 1%,
compared to 6% in bonds. If you assumed that investors wanted a 5% risk
premium, then that means they were expecting to get a compound 10% going
forward from stocks. Instead, they have seen their long-term stock portfolios
collapse anywhere from 40-70%, depending on which index you use.
So what is the actual risk premium?
Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point.
Their conclusion was that the risk premium seems to be 2.5%. Arnott writes:
“My point in exploring this extended stock market history is to demonstrate that the widely accepted
notion of a reliable 5% equity risk premium is a myth. Over this full 207-year span, the average stock
market yield and the average bond yield have been nearly identical. The 2.5
percentage point difference in returns had two sources: inflation averaging 1.5
percent trimmed the real returns available on bonds, while real earnings and
dividend growth averaging 1.0 percent boosted the real returns on stocks.
Today, the yields are again nearly identical. Does that mean that we should
expect history’s 2.5 percentage point excess return or the five percent premium
that most investors expect?
“As Peter Bernstein and I suggested in 2002, it’s hard to construct a scenario which
delivers a five percent risk premium for stocks, relative to Treasury bonds,
except from the troughs of a deep depression, unless we make some rather
aggressive assumptions. This remains true to this day.”
One other quick
point from this paper. Just as capitalization-weighted indexes will tend to
emphasize the larger stocks, many bond indexes have the same problem, in that
they will overweight large bond issuers. At one point in 2001, Argentina was
20% of the Emerging Market Bond Index, simply because they issued too many
bonds. If you bought the index, you had large losses. The same with the recent
high-yield index which had 12% devoted to GM and Ford. In general, I do not
like bond index funds, and this is just one more reason to eschew them.
So Then, Bonds for the Long Run?
Let me be clear here. I am not saying you should put your portfolio in 20-year bonds, or that I
even expect 20-year bonds to outperform stocks over the next 20 years. Far from
it! The lesson here is to be very careful of geeks bearing charts and graphs (it
will be a challenge for my Chinese translator to translate that pun!). Very
often, they are designed with biases within them that may not even be apparent
to the person who created them.
Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, “I have
students of mine – PhDs – going around the country telling people
it’s a sure thing to be 100% invested in equities, if only you will sit out the
temporary declines. It makes me cringe.”
When someone tells you that stocks always beat bonds, or that stocks go up in the long run,
they have not done their homework. At best, they are parroting bad research
that makes their case, or they are simply trying to sell you something.
As I point out over and over, the long-run, 20-year returns you will get on your stock
portfolios are VERY highly correlated with the valuations of the stock market at
the time you invest. That is one reason why I contend that you can roughly time
the stock market.
Valuations matter, as I wrote for many chapters in Bull’s
Eye Investing, where I suggested in 2003 that we were in a long-term
secular bear market and that stocks would be a difficult place to be in the
coming decade, based on valuations. I looked foolish in 2006 and most of 2007.
Pundits on TV talked about a new bull market. But valuations were at nosebleed
levels. And now?
I have been doing a lot of interviews with the press, with them wanting to know if I think
this is the start of a new bull market. There are a lot of pundits on TV and in
the press who think so. I also notice that many of them run mutual funds or
long-only investment programs. What are they going to do, go on TV and say,
“Sell my fund”? And get to keep their jobs?
Am I accusing them of being insincere? Maybe a few of them, but most have a built-in bias
that points them to the positive news that would make their fund (finally!)
perform. And believe me, I can empathize. It is part of the human condition.
But you just need to keep that in mind when you are thinking about investing in
a new fund, or rethinking your own portfolio.
P/E Ratios at 200? Really?
Just for fun, when I was interviewing with the New
York Times today, I went to the S&P web site and looked at the earnings
for the S&P 500. It’s ugly. The as-reported loss for the S&P 500 for
the 4 quarter was $23.16 a share. This is the first reported
quarterly loss in history. That almost wipes out the expected earnings for the
next three quarters. For the trailing 12 months the P/E ratio, as of the end of
the second quarter, is 199.97. Close enough to 200 for government work.
But it gets worse. The expected P/E ratio for the end of the third quarter is (drum
roll, please) 258! However, taking the loss of the fourth quarter off the
trailing returns allows us to get back to an estimated P/E of 23 by the end of
2009. The problem is that you have to believe the estimates, which I have shown
are repeatedly being lowered each quarter, and which I expect to be lowered by
at least another 25% in the coming months.
Now, much of that loss is coming from the financials, which showed staggering
write-offs of $101 billion, $28 billion coming from (no surprise) AIG alone.
Sales across the board are down almost 9%, with 290 companies reporting lower
This quarter the estimated consensus GDP is somewhere between down 5% to down 7%.
Last quarter we were down an annualized 6.3%. That would be two ugly quarters
back to back. It is hard to believe earnings for nonfinancial companies are
going to be all that much better.
Side note: The economy did not contract at 6.3% in the 4 quarter. That is an
annualized number. The quarter actually contracted at about 1.6%. If we go a
whole year with a 6% contraction, that would be truly horrendous. We would blow
right on through 10% unemployment. While it is possible, we should start to see
somewhat better numbers in the second half of the year, although I still think
they will be negative.
Mark-to-Market Slip Slides Away
But it is quite possible that the financial stocks see an improvement in earnings
this quarter. The US Financial Accounting Standards Board (FASB) changed the
mark-to-market rules last week, which many (including your humble analyst)
thought was needed. First, they suspended the mark-to-market rules for assets
in distressed markets. Second, they widened the definition of “temporary”
impairments of troubled assets, which will “allow banks to write up the value
of some troubled assets if these have been hit by falling markets without (yet)
suffering any significant credit losses.”
important part. The board decided to make the new changes effective
immediately, prior to full board approval on April 2.
As my friend Charles Gave noted, this will allow banks to write up their paper,
and it happens before Treasury Secretary Tim Geithner starts putting taxpayer
money at risk. Expect to see a pop in valuations. It will be interesting to see
if Citi and B of A post profits this quarter.
(I should note that the International Accounting Standards Board sent out a scathing press
release. I guess from that we should assume that European banks will not be so
fortunate as their US counterparts.)
In theory, as I understand it, the information will still be there, but the way it will be
recorded will not be reflected in the profit and loss statement. I understand
that this is a very controversial proposal, and I expect many readers will
disagree. The key is whether or not the information is available to investors
and how the proposals are put into actual practice. If there is abuse, and
regulators should be all over this, then the old rules must quickly go back
This could put some strength back into financials, at least until the commercial mortgage and
credit card problems start having to be written off. At the least, it could
make for another solid rise in the stock market until we start to get what I
expect to be very bad 1 and 2 quarter earnings.
Housing Sales Improve? Not Hardly
I opened the Wall Street Journal and read that new home sales were up in February. Bloomberg reported that sales were “unexpectedly” up by 4.7%. I was intrigued, so I went to the data. As it turns out, sales were down 41% year over year, but up slightly from January.
But if you look at the data series, there was nothing unexpected about it. For years on end, February sales are up over January. It seems we like to buy homes in the spring and summer and then sales fall off in the fall and winter. It is a very seasonal thing. If you use the seasonally adjusted numbers, you find sales were down 2.9% instead of up 4.7%. But the media reports the positive number. Interestingly, they report the
seasonally adjusted numbers for initial claims, which have been a lot better than the actual numbers. Not that they are looking to just report positive news, you understand.
Plus, as my friend Barry Ritholtz points out, the 4.7% rise was “plus or minus 18.3%”. That means sales could have risen as much as 23% or dropped 13%. We won’t know for awhile until we get real numbers and not estimates. Hanging your outlook for the economy or the housing market on one-month estimates is an exercise in futility, and could come back to embarrass you.
But that brings up my final point tonight, and that is how data gets revised by the various
government agencies. Typically with these government statistics, you get a
preliminary number, which is a guess based on past trends, and then as time
goes along that data is revised. In recessions like we are in now the revisions
are almost always negative.
There is no conspiracy here. The people who work in the government offices have to create a
model to make estimates. Each data series, whether new home sales, employment,
or durable goods sales, etc., has its own unique sets of characteristics. The
estimates are based on past historical performance. There is really no other
way to do it.
So, past performance in a recession suggests higher estimates than what really happens. Then,
the numbers in the following months are revised downward as actual numbers are
obtained. But the estimates in the current months are still too high. That
makes the comparisons generally favorable, at least for one month. And the
media and the bulls leap all over the “data,” and some silly economist goes on
TV or in the press and says something like, “This is a sign that things are
stabilizing.” It drives me nuts.
Ignore month-to-month estimated data. The key thing to look for is the direction of the revisions. If
they are down, as they have been for over a year, then that is a bad sign.
Further, one month’s estimates are just noise. Look at the year-over-year
numbers. When the direction of the revisions is positive and the year-over-year
numbers are starting to stabilize, then we will know things are starting to
La Jolla, Copenhagen, London, etc.
April is a travel month. Next week I am going to a presentation in Irvine on the
state of stem cell research, which I must admit fascinates me. Then I’m in La
Jolla for my Strategic Investment conference, co-hosted with my partners
Altegris Investments. Then home for a week. Easter weekend, all seven kids
will be home. Then the next week I go to Copenhagen for a board meeting; and I
will be in London, Thursday April 16 to meet with my European partners,
Absolute Return Partners, and clients. The next weekend I go back to California
for a conference, and then the next week I’ll be a day or so in Orlando, where
I’ll speak at the CFA conference on the state of the alternative investment
While I’m in London, I need to drop by and buy a pint for David Stevenson, a
columnist for the Financial Times.
Seems that he was asking his readers for nominations for best financial
websites. For whatever reason, he decided I deserved a special award: “Best
online commentator goes to US analyst John Mauldin, whose weekly letters at
www.frontlinethoughts.com are required reading for all the big City-based bears
I encounter.” It’s nice to be appreciated.
At the end of May (29-31), I will be in Naples, where I will be doing a seminar with Jyske
Global Asset Management and Gary Scott. I will try to line up a web site where
you can see whether you would like to attend.
It’s after midnight and time to hit the send button. The day simply vanished on me,
although I did get to the gym, at least. I am working hard, but somebody turned
the dial down on my metabolism.
Have a great weekend. It is spring in the northern hemisphere, and the azaleas in Texas are
awesome this year. Make sure you stop and enjoy nature a little this spring (or
fall, for you blokes Down Under).
Your getting more skeptical of data as I get older analyst,
Copyright 2009 John Mauldin. All Rights Reserved
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John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
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