Monday Morning: A case for parity between stocks and bonds

Contrary to popular wisdom, stocks don’t always deliver higher returns than bonds, even in the long run.

History is full of periods in which bonds outperformed – or at least matched – stocks in total return. We may be in one of those phases now.

In fact, for the 30 months ended June 26, the total return on long-term Treasury bonds outpaced that of stocks by 50%, indicates James Paulsen, the Minneapolis-based chief investment officer of Wells Capital Management. Even more surprising, a 20-year bond has outperformed the Standard & Poor’s 500 stock index for the past six years.

That’s pretty amazing, considering that for most of that time, investors had little interest in bonds. The stock market’s seeming promise of extraordinary returns for the indefinite future gave them little reason to be interested.

Of course, today’s high bond returns are the result of the strong stock market correction we’ve experienced over the past two and a half years. It’s entirely possible that stock and bond returns over the next five or six, or perhaps even 10, years could march in near lock step, with no clear winner.

It has happened many times before, Mr. Paulsen points out.

For example, between 1870 and 1900 there was little to choose between stock and bond returns. Likewise, for the entire period between 1910 and 1945, the returns were basically equal. Of course, for shorter periods within that time frame, such as the 1920s, stocks outperformed bonds by a good margin, and for others, such as the 1930s, they underperformed by similar margins.

More recently, during the 1966-to-1977 period, bond returns and stock returns basically were equal. Such circumstances mean the investor earns a better risk-adjusted return in bonds than in stocks.

Typically, the matching performance in bonds follows a period of sustained stock outperformance, such as we saw from 1982 through 1999.

The question is, where are we now in the cycle? Are we in the middle of the period of competitive bond performance, at the beginning or near the end?

That depends to a large extent on the Federal Reserve’s actions, and those actions depend on the pace of any economic recovery and stock market recovery.

If the economy remains weak, and the stock market doesn’t recover, the Fed may feel the need to cut rates further to stave off deflation. That would extend the period of competitive bond returns.

If, however, the economy gains momentum too quickly, and the stock market appears to be settling into another bull period, the Fed is likely to try to slow things down with an interest-rate increase. That would end competitive bond returns because it would hurt bond prices while helping stock prices.

Mr. Paulsen makes the case that the inflation outlook is “great.” He points out that the annual rate of consumer price inflation is close to 1%, and there is a “deflationary undertow” to the economy. That’s because companies are quick to cut spending and are reluctant to expand, while consumers know that if they delay their spending, prices seem to fall, and they can buy more cheaply.

Given that, the chances the Fed will raise rates anytime soon are small, though not non-existent.

On the other hand, there is little chance the Fed will cut rates further. So while there may be little risk in bonds, there appears little chance of significant improvement in their returns.

And, as Mr. Paulsen notes, the outperformance of bonds over stocks over the past 30 months hasn’t been equaled since the pit of the Great Depression. As a result, stocks have been cheapened relative to bonds.

Stocks’ turn soon?

All of that suggests there is more opportunity now in stocks than in bonds. Perhaps it’s time to increase the weighting of the average portfolio toward stocks again, at least for the short run.

Mr. Paulsen, like a growing number of analysts, expects stocks to provide “buy and hold” returns of only about 5% per year in the long run, but tactical shifts of asset mix may make sense.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.