Stocks Versus Bonds: A Historical Perspective

Long before the current generation of investors entered the arena, market participants expected (nay, demanded!) that stocks pay out more in dividend yields than bonds did in interest. That is, because stocks are inherently more speculative than bonds, shareholders required a larger payout for the extra risk being assumed. After all, should a company go belly up, bondholders, having extended the company credit, are first in line to get paid when assets are liquidated. By the time the remains are divvied up, there’s usually little, if anything, left for the owners of common shares.

But times change, of course, and every generation or two there’s usually a market shakeup that rattles investors’ previously held beliefs. Prior to the 1920s, stocks weren’t even considered “investments”. They were looked upon strictly as pure speculations, including those that paid out dividends. Bonds, though risky in their own way, were the vehicle of choice by the monied crowd. But some studies came out around the mid-1920s showing that if you held on long enough, you could do better with a basket of equities. This shift, along with the prosperity and easy credit of the times, helped drive stocks to record high levels. Of course, then came the infamous crash. Although it took a few  years, with stocks grinding down to an eventual loss of nearly 90% from the peak, it finally sank in that stocks don’t always go up.

This led to an entire generation shying away from Wall Street. And rightfully so, as it turns out. On a nominal basis, the market did not revisit its 1929 highs for 25 years, while bond returns flourished.  Even worse, after adjusting for inflation, any investor who got into stocks at the top (and happened to hold on) would not have broken even until 1966, nearly four decades later.

Role Reversal

Jumping ahead a few generations, we now find ourselves in a world where investors are once again starting to question whether buying and holding stocks for the long term is such a sure thing. Indeed, the last 10 years has been one of those rare periods where stocks are no higher than where they were a decade ago. But unlike prior periods when stocks fell out of favor, fixed-income investments don’t look quite so appealing right now. Namely, the bond market has enjoyed a near 30-year bull market and It’s probably a little late to join that party.  Back in the early Eighties, rock-solid Treasuries had juicy double-digit interest rates. As investors locked in the high payouts, prices steadily went up and yields gradually fell back. This trend was greatly accelerated with the recent flight to quality in the wake of global economic, banking, and monetary concerns, and their ongoing residual effects. Indeed, investors have been moving out of stocks and piling into bonds in record numbers, to the point where yields have come down to historical lows.

Show Me The Money

investors have become increasing aware that there are few places where they earn any sort of decent income on their cash these days. Bank accounts, are unfortunately not one of them.  In many cases it may cost you just to keep the account open. Money market funds used to be a nice alternative, but the payout is now only a few 10ths of a percent above nothing. And those good old trusty government bonds? Well, the benchmark 10-year Treasury note currently pays out 2.51% (down from a 52 week high of 4.0%). Meanwhile, thanks to lower stock valuations and recovering earnings, the Dow Jones Industrials now yield 2.53%. Another crossing of stock and bond yields occurred briefly last November during the peak of the 2008/2009 financial meltdown. But for the last time before that, you have to go back about 50 years.

Blue Chips Shine

It’s notable that these are not iffy, fly-by-night companies, or corporations down on their heels and perhaps borrowing to maintain their dividends. Investors can easily find high-quality blue chips that have been around for generations and make products that are readily recognized and understood. Among some of the more prominent issues can be found such household names as Kimberly-Clark (KMB) yielding 3.97%, Heinz  (HNZ, 3.73%), Kraft Foods (KFT, 3.65%), Johnson & Johnson (JNJ, 3.47%), Kellogg (K, 3.22%), McDonalds (MCD,3.17%), Procter & Gamble (PG, 3.12%), Coca-Cola (KO, 3.04%), Eli Lilly (LLY 5.24%), Bristol-Myers Squibb (BMY,  4.65%), and AT&T (T, 6.00%). They all make popular and necessary products that are fairly resistant to changes in discretionary spending, and all these companies have the financial wherewithal to maintain their long records of consistent (and in most cases, steadily rising) dividend payments.

Flipping the Inflation/Deflation Coin

Deflation fears have also played a part in the changing relationship between stock and bond yields. When expectations for inflation are high, bond investors demand higher yields in compensation for the expected loss of buying power. In a deflationary environment, the reverse holds true as bond holders are willing to accept lower returns, knowing that their regular dividend payouts will increase in buying power.

As it stands now, bond investors appear to be betting on the latter. But with the Federal Reserve (and several other major central banks) aiming to step up their efforts at quantitative easing (effectively printing money), it’s not too far fetched an assumption that inflation, and thus, rising interest rates, will eventually win out.

Some Caveats

For one thing, large drops in bond yields have often signaled trouble ahead for stocks. As the market wisdom goes, the bond crowd tends to be a stodgy, conservative bunch that doesn’t like to take chances with their hard earned cash. Furthermore, the bond arena is considerably larger than the equity markets, and it tends to be dominated by institutional players with dedicated research teams ever alert to changes in the investment climate.

More to the point, if these folks are right, the higher relative payouts being offered by stocks would not be enough to offset significant market gyrations, and we’ve had some fairly outsized ones in recent years. Even under relatively sedate conditions, a whole year’s dividend could be wiped out in an afternoon’s price movement. Plus, while stocks may be more reasonably priced compared to bonds these days, major bear market bottoms have historically resulted in common stocks generating yields in excess of 6%.  So they’re not exactly slam-dunk, screaming buys just yet.  Furthermore, if the Bush tax cuts are allowed to expire it could deflate ultimate returns to investors.

The Case For Equities

On the other side of the ledger, although bond yields could fall further or stay down for years, mathematically there’s a lot more room for them to climb. And even relatively small percentage increases could spell disaster for bond holders who own them through mutual funds, as many retail investors do.

Also in favor of equities, they offer some potential upside, both in terms of the dividend payout being increased and/or market valuations expanding as business conditions recover.  In contrast, when you buy a bond, the coupon you receive never changes, but the market price is vulnerable to rising interest rates.

Furthermore, dividends often help create a price floor under higher quality stocks. This may lead to a skewing of the market towards top names, while companies that have low or nonexistent payouts lose favor. Add to this the fact that companies are holding record amounts of cash on their balance sheets, and it increases the likelihood that payouts will rise. (See related article.)

While no one can determine if stocks or bonds will be the better performer over the next decade, at least stocks have become relatively more attractive. To be sure, dividends can be cut if the economic recovery loses steam or reverses. But even if the markets should spend another 10 years going nowhere, as long as current rates are maintained, investors stand to do better in equities.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.