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On The Economy, Bonds & Bear Market Rallies |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. First Quarter GDP Falls More Than Expected 2. Stocks Always Outperform Bonds, Right? Wrong! 3. Should You Put All Your Money in Bonds? No! 4. Is the Current Market Rally Too Big to Fail? 5. Conclusions – Not Out of the Woods Yet Introduction Last Wednesday the government reported that 1Q GDP declined at an annual rate of 6.1%, thus confirming that we are still in a deep recession. While the GDP report was worse than the pre-report consensus, it was very much in line with what I predicted in my April 21 E-Letter. I continue to believe that we will be in this recession all year. Several recently released studies highlight the fact that long maturity Treasury bonds have outperformed stocks over the last 40+ years, and by a substantial margin over the last 28 years. I will examine these reports as we go along. Does this mean you should put all of your money in bonds now? I’ll tell you why I believe that would be the wrong move to make at this time. Finally, we get calls every day asking if the recent rally in the stock markets means that the bear market is over, or if this is just a bear market rally. While no one knows for sure, we will take a look at some past bear market rallies to keep things in perspective. I think you’ll find this week’s letter interesting. GDP Falls More Than Expected (But Not to My Readers) The Commerce Department reported last Wednesday that 1Q GDP fell at an annual rate of 6.1%. The pre-report consensus called for a drop of 4.7%, so the actual report came as a negative surprise to the markets (but not to those of you who read my April 21 E-Letter). The decrease in real GDP in the 1Q primarily reflected negative contributions from exports, inventory investment, equipment and software, and decreases in commercial and residential construction. There were, however, a few bright spots in the latest GDP report, particularly in regard to consumer spending. The GDP report last Wednesday noted that personal consumption expenditures (consumer spending) increased at an annual rate of 2.2% in the 1Q in contrast to a decrease of 4.3% in the 4Q. That number seemed unusually high to me in light of the continued plunge in consumer confidence in the 1Q (more on this below). Durable goods orders increased 9.4% in contrast to a decrease of 22.1% in the 4Q. Nondurable goods orders increased 1.3% in contrast to a decrease of 9.4% in the 4Q. These are encouraging signs but were overwhelmed by the bad news in the 1Q. Commercial construction plunged 37.9% year-over-year in the 1Q, even worse than the 21.7% decline in the 4Q. Residential construction decreased 38.0% in the 1Q compared with a decrease of 22.8% in the 4Q. Equipment and software purchases decreased 33.8% compared with a decrease of 28.1% in the 4Q. Exports of goods and services decreased 30.0% in the 1Q compared with a decrease of 23.6% in the 4Q. Imports of goods and services decreased 34.1% compared with a decrease of 17.5% in the 4Q. The bottom line is that if we had not seen the pickup in consumer spending and durable goods orders, the 1Q GDP number could well have been down 8-10%. The recession is still quite severe, and I continue to predict that it will be with us all year. It remains to be seen if the next 1Q GDP update on May 29 will include a downward revision from the -6.1% number reported last week. If so, that may not be good news for the markets. Stocks Always Outperform Bonds, Right? Wrong! The conventional wisdom going back over a century is that stocks outperform government bonds over time, right? Surely most everyone reading this has been taught that axiom over the years. It’s your basic Investing 101 gospel. It’s also the financial planning gospel. It goes like this: stocks are more volatile than bonds, but they deliver a fairly significant return premium over bonds in the long-term. Since government-backed bonds are considered safer, if held to maturity, then it only stands to reason that they would deliver somewhat lower returns than stocks over time. So as a general rule, you should invest more heavily in stocks over bonds when you are younger and have lots of years to ride out the occasional bear market. Then, as you get closer to retirement age, you begin to scale back your equity allocation and invest more in government bonds. Many traditional asset allocation and financial planning models suggest something in the range of a 60/40 stocks/bonds split when you are younger and over time moving to a 40/60 stocks/bonds split – and then even more in bonds as you hit retirement. Yet this conventional wisdom has come under increased scrutiny recently. Why? Since we’ve had two serious equity bear markets in the last decade, Treasury bonds have now outperformed equities over the last 30-40 years. Many financial academics and Investment Advisors are now seriously rethinking their long-held beliefs about bonds. (You might note that yours truly never believed you should have all of your money in stocks and bonds only, but that’s another story for another time.) Given the severity of the recent stock market debacle, with the benchmark S&P 500 Index plunging almost 45% since the peak in late 2007, the long-term performance numbers for stocks-versus-bonds have changed. Government bonds now have somewhat higher returns than stocks, especially over the last 30-40 years. Let’s look at the numbers. If we look back from 1801 (for some reason this is a popular historical date) to today, stocks did beat government bonds by apprx. 2.5% per year on average, which is huge considering the compounding effect over more than two centuries. This is the basis for claims that stocks beat bonds over the long-term. But these days, the “long-term” is hardly measured by multiple centuries. Today, a long-term investment horizon is more typically three to five years, or 10 at tops. But even if we are to look back 200+ years, we see several long periods in which Treasury bonds beat stocks, including the last 30-40 years. Bonds outperformed stocks in the following time windows: 1803 to 1871 (68 years); 1929 to 1949 (20 years);and yes, 1968 to 2009 (41 years). The implications of this are quite interesting. While Treasury bonds can be quite volatile at times, they always pay off in full if held to maturity. Stock investors have no such guarantee. As a result, stocks are supposed to provide a “risk premium” of a couple percentage points or more, at least historically, to pay for that chance their price could drop (potentially to zero). Yet as noted above, stocks have not lived up to that historical expectation over the last 30-40 years, not to mention the current bear market. Based on the actual returns in stocks and bonds over that period, you could have chosen one of the safest investments in the world and performed better than those following Wall Street’s buy-and-hold forever mantra (which I have never believed should be one’s only strategy).
Bonds Really Outperformed Over the Last 28 Years Economist and author A. Gary Shilling recently published an interesting study on the performance of stocks versus bonds over the period from 1981 to early 2009. For purposes of illustration, Shilling assumed that one bought a 25-year zero-coupon T-bond at the all-time low in October 1981 when long-bond yields were well above 14%. Each year thereafter, he rolled it into another 25-year bond to maintain the 25-year maturity and reinvested the income. By comparison, Shilling assumed that one bought the S&P 500 Index at its low in July 1982 and reinvested the dividends each year. Then he tracked the performance of both investments through the end of March 2009. The results are quite surprising! Of course, keep in mind that we have seen one of the largest declines in interest rates and inflation in history over the last 28 years, along with two major bear markets in stocks in the last decade. Shilling found that the 25-year zero-coupon bond delivered an average annual return of 20.4% over the 28 years, while the S&P 500 gained an average of only 10.7% annually over the period from 1981 through March 2009.
Actually, you can go all the way back to 1969 and long-bonds (Treasuries with 20-year or longer maturities) still beat the S&P 500, but only by a marginal amount. So, Should You Put All Your Money in Bonds? No! Given that bonds almost doubled the returns of the S&P 500 over the last 28 years, and given that the S&P 500 fell 37% last year and is still down in 2009, you might think it’s time to put all or most of your money in Treasury bonds. I do not recommend doing so. First of all, interest rates today are the lowest in many years. The 20-year and 30-year Treasury bond yields are currently well below 4%, which is extremely low. The 10-year T-bond is well below 3%. Sooner or later the inflation threat will sink in, and bond rates will rise, possibly significantly. With trillion dollar budget deficits as far as the eye can see, and with other trillions being spent on bailouts, toxic asset purchases, etc., there is little doubt that the US will experience a significant increase in inflation in the years ahead. Some fear we will see hyperinflation given the unprecedented spending by President Obama. Therefore, now could be one of the worst times to load up on Treasury bonds. Stocks, on the other hand, remain quite depressed. The S&P 500 Index is down apprx. 45% from the highs back in late 2007. While no one knows if the early March lows are “the bottom,” stocks are much cheaper in terms of value today than are bonds, which are in my opinion over-valued. The question before us is not what happened over the last four decades, but what might happen in the future. One Internet blog entry that I read noted that a call to invest in bonds right now may be similar to John Bogle's (of Vanguard fame) advice in the late 1990s to buy a S&P 500 Index fund and hold it for the foreseeable future. Given that we have experienced two major bear markets since then, that advice was obviously wrong! There are several bond studies coming out that basically reach the same findings as Gary Shilling’s numbers quoted above. So bonds are getting a LOT of attention of late. While all this attention is almost sure to drive more investors to bonds, I would not follow the crowd by selling stocks and equity mutual funds to buy Treasury bonds, which will go down in value if interest rates rise. Is the Current Market Rally Too Big to Fail? We have heard a lot since last year about institutions that were deemed “too big to fail” and were thus eligible for billions in government bailouts. While it’s admittedly a bit different in the stock market, there are market analysts and investors who are claiming that the sheer size of the recent market rally means that the bear market is over and happy days are here again; in other words, this 25% rally is “too big to fail.” While all of us would like to believe that the bear market has run its course, I’m afraid that we can’t make that judgment based on the size of the recent rally. To illustrate this point, I’ll reference an excellent example that I came across the other day. The illustration begins with a question: What would an investment of $100,000 be worth if it was invested over a three year period that benefited from the following stock market rallies.
+48.0% The natural inclination is to assume that the $100,000 would be worth far more at the end of the three-year period. Compounding the original $100,000 investment by the returns above results in an ending value of almost $400,000. However, we know that markets don’t go straight up, and there were also some down periods during this timeframe. So we have to reign in our guess to something less. So, what about $200,000 to $250,000? That sounds like a reasonable range, doesn’t it? Well, the correct answer is only $10,800! Yes, over this particular three-year period, $100,000 invested in the Dow Jones stocks would have lost almost 90% of its value. Surprised? Shocked? I have to admit that this illustration is somewhat of a trick question because it conveniently leaves out the fact that these market rallies occurred over the three years between September 1929 and July of 1932, the darkest period ever for the US stock markets. During this time, the down periods were far worse than the market rallies, so a $100,000 investment in the stock market lost over 89% of its value. While the above illustration is designed to generate a surprise reaction, it also makes a very important point in regard to bear market rallies. Very rarely do bear markets go straight down, just as no bull market goes straight up. There are almost always “corrections” in the short-term trends, and these reversals are frequently large enough to convince investors that the major trend has changed as well. This can be very costly, especially if they make a change, only to find that the correction was just that, and then the major trend continues. After the Crash of ’29, there were several powerful market rallies that followed. Just as now, I’m sure there were stock market pundits back then claiming that a new bull market had surely begun during some of these rallies, especially the one in late 1929 to early 1930 that gained 48% over the course of 22 weeks. While the 1929–1932 period was the most prominent example, other notable bear markets have had strong rallies that proved to be false alarms. One Internet source I consulted noted that the 1973–1974 bear market had two bear market rallies of apprx. 10%, and the 2000–2002 bear market had three substantial rallies with the smallest being 19%. Even the current bear market that began in October of 2007 has had four double-digit rallies, including the one we’re in right now. Each of the preceding rallies has provided hope to market participants and drawn many of them back into the market, only to see their investments dwindle further. As I have mentioned in these pages several times, I am not sure that we have seen the end of this bear market, especially if we learn in the coming weeks that some or many of the largest insurance companies are in trouble. While I am willing to consider the possibility that the March 9 low was the bottom of the market, I also believe that we are very likely to at least retest this low again in the future. A good example of the market retesting its prior lows is the period of time from July of 2002 to March of 2003. The statistics on the 2000–2002 bear market indicate that the S&P 500 Index hit an intra-day low of 768.67 in October of 2002. However, when you look at a chart of the S&P 500 Index during that period of time, you see that we came very close to the October 2002 intra-day low in July of 2002 (775.96) and again in March of 2003 (788.94). Chartists call this a “triple bottom.” I would not be surprised to see a similar situation occur in 2009.
What Should You Be Doing? There’s an old saying that you should “hope for the best but plan for the worst.” I think that’s where we are today in the stock markets. With the unprecedented government intervention in the credit markets and even corporate ownership, we are sailing in uncharted waters. Politicians, who are always happy to see a healthy stock market, now have an even greater incentive to make sure the economy pulls itself out of the ditch. No one wants to run for re-election with the stock market in a slump, especially when the government controls some of the nation’s largest banks and corporations. Therefore, while we all hope that the March 9 low set the bottom of the current bear market, we have to plan as though there’s more pain to come. There are a number of ways you can do so, including:
In light of the current stock market situation, I am reminded of a conversation I had many years ago with a very successful active money manager. We were discussing the higher management fees charged by active managers, typically in the 2-2½% range annually. I made the comment that I believed such fees were justified in return for getting investors out of the market during serious downturns. The manager responded as follows (more or less verbatim):
That conversation comes to mind because we hear from so many people who got out of the stock market late last year or early this year, and they have no idea when to get back in. That’s when having a time-tested mechanical timing system directing a portion of your portfolio can be very valuable. Conclusions – Not Out of the Woods Yet Following the release of the 1Q GDP report last Wednesday, the Dow Jones promptly rallied 200 points, and the S&P 500 gained 22 points – even though the overall GDP report (-6.1%) was worse than expected. People reacted to the increase in consumer spending in the 1Q as a sign that the recession may be ending. Yet if we dissect the numbers within the GDP report, as I did above, we find that most sectors of the economy declined at an even faster pace in the 1Q. These facts suggest that this recession has not hit bottom and will be with us for some time to come. It may be that the 1Q proves to be the worst part of the recession. Most economists expect the decline in GDP to be smaller in the 2Q and even smaller in the 3Q. While those estimates may prove to be correct, we saw no convincing evidence that the recession was starting to bottom in the 1Q. Given that, I think we can dismiss forecasts calling for a return to positive GDP in the second half of this year. Also keep in mind that there may be more bad news for the credit crisis just ahead. As I discussed at length in my April 7 E-Letter, there is plenty of evidence that some of the largest insurers in the US are in financial trouble. Some are pleading for bailouts, and it is probably reasonable to expect they will get them. But this news is getting hardly any media attention thus far. So this could be the next shoe to drop in the credit crisis. Obviously, it is very difficult to know what to do with your investments in times like these. Investors who are on the sidelines wonder if they should jump back in. People who rode the market all the way down are wondering if they should now get out. Based on the calls we get, most investors are still very nervous, even though the stock markets have recovered somewhat. In my Investment Advisory business, we have found that investors mostly want to talk to someone they can trust and explore all of the options. They don’t want to talk to someone who is automatically going to tell them to sell all of their investments and transfer their money to a new Advisor or program, nor do they want to be hounded on the phone or via constant e-mails. Fortunately, we don’t do any of those things at my company. I would like to offer you the ability to talk to any of our Investment Consultants about your investment needs with no cost or obligation to invest of any kind. My company is very different in that all my Investment Consultants are paid a salary, and do not receive commissions or incentive compensation of any kind. Thus, their marching orders are to make sure that our clients’ investment needs are met, even if it means not participating in any of the investment programs we recommend. If you would like to discuss your current investments and/or retirement planning with someone who is not going to pressure you to invest with them, then you are welcome to call one of my experienced Investment Consultants, at no charge to you. You can call us at 800-348-3601, or if you prefer, you can send an e-mail to info@halbertwealth.com and your questions will be immediately routed to one of our staff members. Wishing you profits,
Gary D. Halbert SPECIAL ARTICLES:
Gary Shilling Study: Stocks vs. Bonds
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