Wednesday, May 30, 2012

Is Now the Time to Switch from Bonds to Stocks?

Writing in last Saturday's Financial Times, columnist John Authers surveyed the current investment landscape, and discussed a very basic question:

Is now the time to dump bonds in favor of stocks?

His answer, unfortunately, is a definite "maybe".

Here's what Authers wrote:

At present, as I have said before equities look cheaper versus bonds than they have in half a century...

... Equities do look cheap, relative to bonds, because bonds are incredibly expensive.  All else equal, that should mean people start selling bonds - and buy at least some stocks with the money they release.

But talk to fund managers, and it is obvious that they are buying bonds...because regulations force them to do so.  This is financial repression - to deal with the debt they took on to quell the credit crisis, governments are forcing us all to lend to them at ruinously low rates. While artificial incentives to buy bonds stay in force, bonds could stay expensive - and equities could stay relatively cheap.

In other words, while the data seem to suggest that investors should be running  from the bond market, it could be several years before the switch bears fruit.

We've been through periods like this before.

For example, in December 1996 Federal Reserve Chairman Alan Greenspan publicly questioned whether stock markets were in a state of "irrational exuberance". 

Well, they were, but the S&P doubled in the next four years before finally collapsing.

Further back, in 1979, Warren Buffett wrote an article for Forbes titled "You  Pay A Very High Price for a Cheery Consensus". 

What he wrote more than 30 years ago sounds very similar to the situation today:

Stocks now sell at levels that should produce long-term returns far superior to bonds. Yet pensions managers, usually encouraged by corporate sponsors they must necessarily please ("whose bread I eat, his song I sing"), are pouring funds in record proportions into bonds....

 A simple Pavlovian response may be the major cause of this puzzling behavior. During the last decade, stocks have produced pain--both for corporate sponsors and for the investment managers the sponsors hire. Neither group wishes to return to the scene of the accident. But the pain has not been produced because business has performed badly, but rather because stocks have underperformed business. Such underperformance cannot prevail indefinitely, any more than could the earlier overperformance of stocks versus business that lured pension money into equities at high prices.

The S&P 500 has traded at 1550 twice over the past 12 years:  in 2000 and 2007.  These levels are more than 14% higher than the market today.

However, earnings for the companies that constitute the S&P are much higher than in prior periods.

Analysts expect the S&P to earn $102 per share in 2012, which would +15% higher than the S&P earned in 2007 and more than double S&P earnings in 2000.

In other words, to paraphrase Buffett:  stocks have performed poorly over the last decade not because business has performed poorly but rather because stocks have underperformed businesses.

But if you had bought stocks in 1979, you would have lost -5% over the next three years (even more on an inflation-adjusted basis).  It wasn't until 1982 that the Great Bull Market began.