The late 1970s were an absolutely brutal time for investors.
Stagflation ruled the roost asinflation spiraled out of control and
economic growth remained anemic. Yet, investors wise enough toload
up onbonds made an absolute killing. Double-digit yields were easy
to find and investors who held these bonds into the next decade or
two saw strong gains (asbond yields steadily fell).
In fact, the era of falling bond yields continued up until
today. Each time we thought bonds couldn't go any lower, they
dropped more. Take a look at what has happened to 10-year
U.STreasuries during the past two decades.
Watching the 10-year Treasury reach yields of just 1.7% is a
moment few of us thought we'd ever see. As I'll explain in a
moment, this lowyield is unlikely to last. One thing's for sure: it
is almost impossible for yields to drop even lower. With such
paltry yields in place and little hope for rising bond prices
(which happens when yields fall lower), this is the absolute worst
time to be buying more government bonds. (And it's a great time to
sell any bond funds that have recently appreciated sharply in
value).
But many are doing the opposite by shunning stocks and loading
up on bonds. Retail investors have pulled an estimated $12.5
billion out of stocks andmutual funds thus far in the
third-quarter, while they have poured $25 billion into bonds,
according to the Investment Company Institute (
ICI
).
The economic disconnect
To understand why bonds are now a lousy investment, you need to
look at why bond yields are plunging. Historically, bond yields
have been nothing more than ahedge against inflation. Investors
bought them with a promise of getting a slightly better return than
the rate of inflation -- a modest compensation for taking on the
very minor risk of bond default. In fact, you can track bond yields
during the past 75 years, and they have a remarkable correlation
with inflation rates. But in the past four years, that link has
been broken. After the GreatRecession of 2008, bond yields dropped
toward the rate of inflation, and at some point in 2011, these
yields actually fell below the rate of inflation.
That's because investors stopped buying bonds as a way to hedge
against inflation, but instead sought out bonds simply because no
other attractive investments existed. For the thousands of
investors who have been too uncomfortable to own stocks in this
uncertaineconomy , bonds have been the favored alternative. The
problem is that it's increasingly looking like a very bad
decision.
The inflation hedge is gone
As noted, for the first time in my life, the 10-year Treasury bonds
yield is now below the rate of inflation. This means you'll lose
money buying these bonds (on an inflation-adjusted basis) with the
losses rising higher as the years unfold, thanks to the effect of
inflation. As of now, the 10-year bond yields about 1.65%, while
just-released producer price data shows inflation rose 0.3% in July
(ahead of forecasts of 0.2%). That's just a snapshot in time, but
extrapolates out to an annual inflation rate above 2%.
Inflation concerns have been put on the backburner in recent
years, but it's notable that the capacity utilizationindex -- a key
measure of inflationary pressures -- is approaching a reading of
80, which has historically signaled an inflection point for supply
chain bottlenecks and rising prices.
Let's assume inflation pressures don't quickly emerge and
instead settle into a range of 2.3% inflation. If you buy a 10-year
$10,000 bond now, then you would have $11,778 in a decade. But
$10,000 in today's dollars will inflate to $12,553, which means you
could lose roughly $800 if the bond is redeemed in 2022 after
inflation.
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This assumes inflation remains dormant throughout the period.
But when the economy finally mends, inflation is likely to move
back to the historical 3% to 4% range we saw in the past few
decades. Let's assume inflation stays dormant until 2014, at which
time it rises to 3.5%. By that math, you've lost roughly $2,000 on
the bond investment.
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Yield vs. yield
An argument against bonds is also an argument for stocks. Simply
put, average yield paid out by a typical company in the S&P 500
now exceeds the yield on the 10-year bond. I went into this topic
in great detail back in June
.
In addition to today's superior yields, stocks are proven to be
a better investment than bonds over the long haul. The recent rally
in bond prices is setting up a clear contrast., "In terms of
relative performance, current bond prices in relation to stocks
remain abnormally high from a historical perspective, levels which
have traditionally been a precursor for significant stock
outperformance," noted analysts at the Bank of Montreal (
BMO
).
They back that up with facts. The BMO analysts noted that bonds
handily beat stocks in 1977, 1982, 1985, 1987, 1990, 2002 and 2009.
But those were great times to pivot out of bonds and back into
stocks. "Interestingly, each of these periods were followed by a
prolonged period of stock outperformance (e.g., two years or
greater). From our perspective, stocks are on the verge of
repeating this cycle yet again given recent trends," said BMO in a
recent note to clients.
Risks to Consider:
As a near-term upside risk for bonds, if the European crisis
erupts into full-fledged chaos, then a "flight to quality " could
(temporarily) push bind yields even lower.
Action to Take -->
While I focused on the relative appeal of stocks in my column cited
earlier, this column is a clear, unvarnishedcall on why you should
avoid fresh U.S. government bond purchases. Don't like stocks? Look
to other assets such asreal estate , corporate bonds, foreign
government bonds (that still have appealing yields), collectibles
and any other items that have a history of keeping up with
inflation.
I still think stocks are the way to go. I'm actually
fairlybearish for themarket in coming weeks and months simply
because the market seems to have gotten ahead of itself. The
S&P 500 is already up 10% this year and almost 20% in the past
12 months, despite numerous near-term headwinds.
But with an eye on the long-term, stocks are indeed shaping up
to represent deep value. More to the point, they are a superior
hedge against inflation. You really should only consider bonds
again when the 10-year yield exceeds 3.5%, which should be
perceived as the long-term rate of inflation.
-- David Sterman
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David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.