Something happened last year that wasn’t supposed to happen.
Something that even those hardy souls who lived through the Great Depression didn’t experience first-hand. Something so rare, the last time it happened was in 1861.
Just what was this uncommon, unbelievable, almost unheard-of occurrence? Over the course of the thirty-year period that ended in 2011, bonds outperformed equities.
The reasons for this historic upset are as clear as they are relatively simple. Stocks have offered an effective zero rate of return over the last decade. At the same time, bonds have been on the mother of all rallies since as far back as the early 1980s.
In June 1981, for example, the Fed fund rate hit a whopping 20%. But since rates had been steadily rising alongside inflation throughout the 1970s, most people assumed that 20% was just the beginning. As a result, bonds (which increase in value when interest rates decrease and decrease when rates rise) were essentially ignored.
After all, bonds had done so poorly for so long, very few investors were tempted even by a 20% return. So instead of buying long-term bonds, they lined up to buy gold, farmland or even stamp collections – all of which had likewise risen sharply in value.
When interest rates turned a corner and started heading down again, those poor, neglected long bonds rallied sharply. Ever since, every time rates have dropped, bonds have gone up and up, right through until today.
This little history lesson explains why bonds have had a better return than stocks over the past three decades. But for investors who are less interested in market history, and more concerned with deciding where to put their money now, a better question to ask might be: now that rates are essentially at zero, will bonds continue to go up in value?
Most investors seem to think so. The inflows into bond funds are at record levels, with most of the money coming out of equity funds. This would suggest that most investors believe the current malaise in stocks is going to continue well into the foreseeable future.
But let’s dig a little deeper. Where is this prevailing opinion coming from, and what’s driving investors to arrive at this conclusion?
I believe the answer lies in basic human psychology. Human beings (especially investors) are very fond of looking backwards. On a superficial level, this makes a certain kind of sense. Since the future is unknown, people tend to extrapolate the immediate past into the distant future, under the assumption that things will always be more or less the same as they are now.
In the 1970s, for instance, crime rates were on the rise. As a result, we began hearing dire predictions about how our entire society was on the verge of being overrun by violence and anarchy.
Just about the time the cries of Armageddon were at their most furious, the crime rate did the unthinkable. It dropped. And it has continued to head straight down ever since.
We make the same kind of flawed assumptions when it comes to our investments. Take real estate as an example.
In Canada, residential real estate has been going up pretty steadily for the past 15 years. We therefore tend to believe it will keep going up in value forever. We even ignore all the evidence to the contrary that we’re seeing play out just a few hundred kilometers to the south, because we feel our own immediate experience is all the evidence we really need.
Personally, I don’t think real estate values will collapse in Canada the way they did in the United States. But a steady climb in prices through a long period of declining borrowing rates makes for high prices. This means that the big gains to be had in real estate are likely already in the rearview mirror.
For those willing to turn a blind eye to the “evidence” of the past and focus on the here and now, however, there is a fair bit of evidence accumulating out there to suggest that stocks might not be the dumbest thing you could do with your money.
For instance, while the governments who issue many of those bonds are struggling with huge deficits and out-of-control spending, corporate balance sheets are in the best shape they’ve ever been. The 500 companies that make up the S&P 500 alone have a combined cash hoard of around $3.24 trillion.
Right now 35% of the world’s entire money supply is currently in cash or cash equivalents. In other words, more than a third of the world’s money is sitting in cash or in short bonds that are paying almost nothing.
Yet stocks, unloved because of their recent troubled past, are languishing at valuations that have never been seen before. That’s right – in the history of the markets, stocks have never been as cheap relative to interest rates as they are right now. To add icing to the cake, in most cases, dividend yields are well above the yields for bonds.
There are also some significant signs that we may be about to see the tide turn on the economic doldrums that have been plaguing investor confidence for the past 10 years. Unemployment numbers have begun to fall. Purchasing and manufacturing are both showing steady gains. And corporate earnings have doubled since the trough of 2009.
At some point, investors will clue into the realization that a recovery is either about to begin, or is already underway. When that happens, bonds will give up the leadership position that they held only once before in the last 150 years. And all those undervalued stocks that represent companies with rising dividends and healthy balance sheets may finally start getting some loving.
For the individual investor, the only question is do you want to buy stocks now while they’re still at all-time low prices, and watch your investment grow? Or do you want to wait until after the inevitable rally has occurred, and everyone else finally decides it might be a good idea, too?
Alan MacDonald an Investment Advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of "The Copperjar System, Your Blueprint for Financial Fitness" available on Amazon.
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.