|Monday, 27 April 2009 15:58|
(Editor's note: The following originally appeared as part of the May/June 2009 issue of the Journal of Indexes, "Rethinking Fixed Income." A complete list of the issue's stories can be found here.)
For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns.
A 2.5 percentage point advantage over two centuries compounds mightily over time. But it’s a thin enough differential that it gives us a heck of a ride.
It's also striking to note that, even setting aside the opportunity cost of forgoing bond yields, share prices themselves, measured in real terms, are usually struggling to recover a past loss, rather than lofting to new highs. Figure 2 shows the price-only return for U.S. stocks, using S&P and Ibbotson from 1926 through February 2009, the Cowles Commission data from 1871–1925, and Schwert data5 from 1802–1870. Out of the past 207 years, stocks have spent 173 years—more than 80 percent of the time—either faltering from old highs or clawing back to recover past losses. And that only includes the lengthy spans in which markets needed 15 years or more to reach a new high.
Most observers will probably think that it’s been a long time since we last had this experience. Not true. In real, inflation-adjusted terms, the 1965 peak for the S&P 500 was not exceeded until 1993, a span of 28 years. That’s 28 years in which—in real terms—we earned only our dividend yield … or less. This is sobering history for the legions who believe that, for stocks, dividends don’t really matter.
If we choose to examine this from a truly bleak glass-half-empty perspective, we might even explore the longest spans between a market top and the very last time that price level is subsequently seen, typically in some deep bear market in the long-distant future. Of course, it’s not entirely fair to look at returns from a major market peak to some future major market trough.6 Still, it’s an interesting comparison.
Consider 1802 again. As Figure 3 shows, the 1802 market peak was first exceeded in 1834—after a grim 32-year span encompassing a 12-year bear market, in which we lost almost half our wealth, and a 21-year bull market.7 The peak of 1802 was not convincingly exceeded until 1877, a startling 75 years later. After 1877, we left the old share price levels of 1802 far behind; those levels were exceeded more than fivefold by the top of the 1929 bull market. By some measures, we might consider this span, 1857–1929, to have been a seven-decade bull market, albeit with some nasty interruptions along the way.
The crash of 1929–32 then delivered a surprise that has gone unnoticed, as far as I’m aware, for the past 76 years. Note that the drop from 1929–32 was so severe that share prices, expressed in real terms, briefly dipped below 1802 levels. This means that our own U.S. stock market history exhibits a 130-year span in which real share prices were flat—albeit with many swings along the way—and so delivered only the dividend to the stock market investor. The 20th century gives us another such span. From the share price peak in 1905, we saw bull and bear markets aplenty, but the bear market of 1982 (and the accompanying stagflation binge) saw share prices in real terms fall below the levels first reached in 1905—a 77-year span with no price appreciation in U.S. stocks.
Stocks for the long run? L-o-n-g run, indeed! A mere 20 percent additional drop from February 2009 levels would suffice to push the real level of the S&P 500 back down to 1968 levels. A decline of 45 percent from February 2009 levels—heaven forfend!—would actually bring us back to 1929 levels, in real inflation-adjusted terms.
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My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5 percent 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 5 percent premium that most investors expect? As Peter Bernstein and I suggested in 2002, it’s hard to construct a scenario that delivers a 5 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.
Bonds And Diversification
If 2008–09 teaches us anything, it’s the truth in the old adage: “The only thing that goes up in a market crash is correlation.” Diversification is overrated, especially when we need it most. In our asset allocation work for North American clients, we model the performance of 16 different asset classes. In September 2008, how many of these asset classes gave us a positive return? Zero. How often had that happened before in our entire available history? Never. During that bleak month, the average loss for these 16 asset classes—including many asset classes that are historically safe, low-volatility markets—was 8 percent. Had that happened before? Yes; in August 1998, during the collapse of Long Term Capital Management (LTCM), the average loss was 9 percent. But, after the LTCM collapse, more than half of the damage was recovered in the very next month!
By contrast, in the aftermath of the September 2008 meltdown, we had the October crash. During October, how many of these asset classes gave us a positive return? None. Zero. Nada. How often had that happened before in our entire available history? Only once … in the previous month. How bad was the carnage in October 2008? The average loss was 14 percent. Had so large an average loss ever been seen before? No. As is evident in Figure 4, October 2008 was the worst single month in 20 years for three-fourths of the 16 asset classes shown. For most, it was the worst single month in the entire history at our disposal.
The aftermath of the September–October 2008 crash was, unsurprisingly, a period of picking through the carnage to find the surviving “walking wounded.” As Figure 5 shows, the markets began a sorting-out process in November/December 2008. Some markets—the safe havens with little credit risk or liquidity risk—were deemed to have been hit too hard, and recovered handily. Others—the markets that are sensitive to default risk or economic weakness—were found wanting, suffering additional damage as a consequence of their vulnerability to a now-expected major recession. The range between the winners and the losers was over 3,000 basis points, nearly as wide as in the crash months of September/October, but more symmetrically around an average of roughly zero.
By the time the year had ended, bonds were both the best-performing assets and among the worst-performing assets. Consider Figure 6. The best-performing market on this list was long-duration stripped Treasuries—an asset class used in many LDI strategies—rising over 50 percent in that benighted year. The worst-performing asset is a shocker. It’s an absolute-return strategy—represented as a way to protect assets in times of turbulence—that takes short positions in stocks and long positions in bonds! In a year when the bond aggregates rose 5 percent and stocks crashed 37 percent, this strategy leverages that winning spread. Investors used these convertible arbitrage hedge fund strategies as a source of absolute returns, a safe haven especially in a severe bear market, and got an absolute horror show.
Of course, it was unhelpful that the Convertible Bond Index went from 100 basis points below Treasury yields to (briefly) 2,400 basis points above Treasury yields. Nor was the brief SEC prohibition on short-selling over 1,000 different stocks helpful. Now, as the convertible arb hedge funds deal with their clients’ mass exodus, the convertible bonds are looking for a new home; after all, even if these hedge funds are disappearing, their assets are not.
In 2008, the markets demonstrated that bond categories can be far more diverse and less correlated with one another than most investors previously believed. Indeed, in 2008, that was arguably even more true for bonds than for the broad stock market categories.
The Efficacy Of Bonds
The Problem With Bond Indexes
As investors become increasingly aware that the conventional wisdom of modern investing is largely myth and urban legend, there will be growing demand for new ideas, and for more choices.
Why are there so many equity market mutual funds, diving into the smallest niche of the world’s stock markets, and so few specialty bond products, commodity products or other alternative market products? Today, investors are still reeling from the devastation of 2008, and the bleak equity results of this entire decade. They have already begun to notice that there were opportunities to earn gains, sometimes handsome gains, in a whole panoply of markets in the past decade—most of which are still difficult for the retail investor to access.
Tuesday, April 28, 2009
Bonds: Why Bother? Written by Robert Arnott
Posted by Bud Fox at 1:31 PM