Weekly Commentary November 7th, 2011

The Markets

This Europe problem just won’t go away and it’s keeping the financial markets on edge.

Despite an October 27 agreement that strengthened the bailout of Greece, the “Greek Tragedy” continues as the country’s government is a mess, Prime Minister George Papandreou is reportedly stepping down and the populace is protesting. And, with each day of delay, Greece is running out of money and European leaders are running out of patience.

Meanwhile, across the Ionian Sea from Greece, Italy is quickly becoming the next problem. Its 10-year government bond yield rose to a euro-era record of 6.4 percent last Friday. The Wall Street Journal says, “The 6% mark on the 10-year bond is seen as crucial because a breach of that level in the past has portended a sharp rise in bond yields of other fiscally frail countries.”

When bond yields rise dramatically, it increases a country’s borrowing costs and suggests investors are losing faith in that country’s ability to pay its bills.

Even though Greece is grabbing most of the headlines, Italy is much more crucial to world markets than Greece because Italy’s government bond market is the third largest in the eurozone behind Germany and France. If Italy goes the way of Greece, that would elevate the European crisis to a whole new level.

Ultimately, there’s just too much debt in the worldwide monetary system. Until it gets cut to a manageable level, the markets may behave erratically.

ONE OF THE CORE BELIEFS OF MODERN INVESTING TURNED OUT TO BE not so true. Investors have long believed in “stocks for the long run” and that stocks outperform bonds over a long period of time. Well, we need to re-evaluate that old truism.

New data shows that for the 30 years ending September 30, 2011, long-term government bonds outperformed stocks. During that period, bonds rose by 11.5 percent a year on average, beating the 10.8 percent increase in the S&P 500, according to Jim Bianco, president of Bianco Research in Chicago, as reported by Bloomberg. That’s the first time bonds beat stocks over a 30-year period since the Civil War!

Here’s some long-term historical data on how stocks and bonds have performed relative to each other:

Period # of Years Winner
1803 – 1857 54 Bonds
1803 – 1871 68 Tie
1857 – 1929 72 Stocks
1929 – 1949 20 Bonds
1932 – 2000 68 Stocks
1981 – 2011 30 Bonds
Sources: Bloomberg, October 31, 2011; Index Universe; Ibbotson SBBI

Is this an argument for dumping stocks and just owning bonds? No. The recent outperformance of bonds over stocks was partially a function of the starting point and the “lost decade” for stocks. Specifically, in 1981, long-term government bonds yielded in the 13 to 15 percent range while, last Friday, the yield was down to 3.1 percent, according to data from Yahoo! Finance. As the yield drops, the price of the bond rises, thus, giving investors a capital gain on top of the interest return.

With yields so low now, you won’t get the same capital gain boost from bonds that we experienced over the past 30 years. In fact, Professor Jeremy Siegel, author of Stocks for the Long Run, says, “It’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward.”

Bonds also benefitted from the “lost decade” in stocks as stocks experienced two bear markets in the past 11 years.

This historical data does two things for us:

1. It suggests that there are no “absolutes” when it comes to investing, except, perhaps, that there are no absolutes. Key takeaway – be flexible.
2. It suggests that there is a time and a place for each asset class and placing each asset class within historical context is important. Key takeaway – know history.

Oh, we should add a third key takeaway from this data – be a continuous learner!

Weekly Focus – Think About It

“I'm interested in the way in which the past affects the present and I think that if we understand a good deal more about history, we automatically understand a great more about contemporary life.” --Toni Morrison, Nobel Prize and Pulitzer Prize-winning American novelist, editor, and professor