BUY BONDS! Over the coming decade, investors are likely to fare better with bonds than with stocks.
(MONEY Magazine) – In his 1973 book A Random Walk down Wall Street, Burton G. Malkiel, a noted Princeton University economics professor, lucidly explained the efficient- market theory. Its bottom line for investors is dismaying: no system can consistently beat the market. ''A blindfolded chimpanzee throwing darts at the Wall Street Journal can perform as well as the experts,'' says Malkiel. Not surprisingly, the pros disagree. They concede that stocks and bonds are fairly priced much of the time -- but not all of the time. And they argue that careful analysis can still discover bargain stocks. Now, in the fifth edition of Random Walk ((c) 1990 by W.W. Norton & Co. Inc., $22.95), Malkiel acknowledges that his critics have a point. ''Investors may benefit from a strategy that weds a contrarian approach to a fundamental- value approach,'' he says. In other words, the traditional strategy of looking for solid companies that are out of favor appears to be the best one. And while Malkiel still contends that short-term results are random, he believes profitable long-term decisions can be based on analyzing economic trends. ''Over an interest-rate cycle, relatively high stock returns tend to follow periods of low returns, and vice versa,'' he explains. In the following article, adapted from his new book, Malkiel discusses the wisest strategy for the 1990s. His conclusion: taking risk into account, bonds could outperform stocks. -- Michael Sivy
Investors should always beware of looking in a rearview mirror when choosing investments. In the 1980s, if you had relied on the experience of the previous decade, you would have made exactly the wrong moves. Stocks and bonds gained only 5% to 6% annually during the 1970s, while gold soared at a compound Irate of 21% a year. But in the following decade, stocks and bonds both provided double-digit annual returns as gold rose less than 3% a year. So after the large profits in financial assets over the past 10 years, investors would be justified in wondering whether stocks and bonds are smart choices for the 1990s. The only certainty is that neither of them will precisely repeat their spectacular results in the 1980s. But past performance is not altogether useless as a guide; the levels of stock and bond prices over several decades provide benchmarks that enable you to be more realistic about the returns that you can expect. You can begin your analysis with the chart on the facing page, which compares the returns of stocks and bonds over the past 30 years. My outlook is given in the bottom graph: after the strong gains of the 1980s, stocks and bonds don't look nearly as promising today as they were a decade ago. Still, present price levels and the likelihood that inflation will remain under control suggest to me that stocks and bonds will offer attractive rates of return -- high-quality issues could average 9% or so a year. And of the two, I would bet more heavily on bonds, because their yields look generous by historical standards. Here's how the prospects of stocks and bonds compare: Stocks. After inflation is taken into account, the stock market has been on a treadmill. In real terms, stocks are now selling below their peak levels of the 1960s and early 1970s, despite substantial growth in corporate profits over the past 20 years (see the chart on page 103). As a result, as long as the economy can grow moderately without a surge in inflation, stocks can make further gains. This scenario seems likely, since recent wage and productivity trends suggest that the core inflation rate remains between 4% and 5%. While no stock-picking method can be conclusively shown to beat the market, two principles are supported by recent studies: 1) There is some evidence that stocks with low price/earnings multiples outperform those with high multiples. Since P/Es reflect investors' growth expectations, and earnings growth is hard to forecast, it's wiser to own low- multiple stocks. If surprisingly strong growth materializes, both a stock's earnings and its P/E can increase. By contrast, a high-multiple stock whose earnings fall short may suffer a double whammy -- both the earnings and the multiple can fall. Today even some traditional growth stocks have multiples that are below the market average. 2) Historically, high-dividend yields have meant better returns. Since a fat yield implies that a stock's price is fairly low relative to those of other stocks, looking for above-average yields is itself a contrarian strategy. Further, the stock market generally offers the biggest yields after interest rates have risen. Investing in high-dividend stocks therefore is likely to lead you to attractive issues and encourage you to invest at a favorable point in the interest-rate cycle. Bonds. While long-term Treasury yields, recently around 8.5%, are considerably below the 14% levels of the early 1980s, inflation has come down so sharply in the past 10 years that real yields are still quite attractive, as is shown in the chart above right. High-quality corporate bonds -- those rated at least AA, such as Southern California Edison, Southern New England Telecommunications and Southwestern Bell issues -- typically pay about a percentage point more than Treasuries do. The corporate bond yields, at 9.5% or so, are therefore comparable to the long-term returns that investors can expect from high-quality stocks. Moreover, high-quality bonds are somewhat less risky than stocks. Of course, junk bonds now promise yields at least four percentage points higher than those of high-quality corporates. Some investment advisers argue that the yield advantage of a well-diversified portfolio of junk bonds more than makes up for losses from a few defaults. But there is substantial risk in high-yield bonds. In a broad recession, the number of defaults would balloon, which could reduce the net returns on a diversified junk portfolio to less than the yield on high-grade bonds. Investors who can stand this risk may profit by putting as much as 10% of their portfolios in junk bonds. But you should avoid junk if your investments are a major source of income or if you are investing for a specific future need such as college tuition. If, like most small investors, you want to take the safest course, I recommend that you aim for a return of 9% to 10% by sticking to top-grade issues. Your other important decision is how to divide your portfolio between stocks and bonds. For guidance, you might look at returns on stocks and bonds in recent decades and how both investments are currently priced relative to historical precedents. By three important measures, stocks appear a little on the expensive side (see the chart on page 105). Since 1960, the price/earnings ratio of the S& P 500 has varied from a low of 6.7 in 1980 to a high of 23.2 in 1987. Currently, the S&P's P/E is 16.6, slightly above the midpoint of the range for the past 30 years. Another gauge of market value consists of comparing share prices with the current cost of replacing companies' assets minus the companies' debt. Through much of the 1980s, stocks were selling at discounts from replacement value. Stocks are no longer at a discount. Because replacement values are difficult to calculate, analysts often rely on a cruder but simpler ratio -- how share prices compare with companies' book values. Since they are not adjusted for inflation, book-value ratios tend to overstate how expensive stocks are now. Even so, it appears that prices are closer to their highs than to their lows. The dividend yield of blue-chip stocks is the third commonly used valuation. (A relatively low yield means that stocks are highly priced; the opposite also holds true.) Since 1960 the S&P 500 has yielded as little as 2.6% at market peaks and more than 6% during recessions. With a current dividend yield of only 3.4%, the S&P 500 looks somewhat pricey. Since all three measures indicate that stocks are expensive, I expect investors to find a better balance of risk and return over the next 10 years with bonds. I firmly believe that whenever the yield on high-quality bonds nearly equals the prospective returns on stocks, as is now the case, bonds are the place to be. Bonds are the Rodney Dangerfields of investments -- they don't get much respect. The reason is that they have long underperformed stocks. Over the past 60 years, in fact, Treasury bonds have provided a compound annual return of only about 5% compared with nearly 10% for stocks. With the benefit of hindsight, we now know that bonds were overpriced 30 years ago. If investors had realized that inflation would become a major problem in the 1970s, they would have required higher yields -- that is, lower initial bond prices -- to make up for future inflation. The current high yields on bonds serve as another reminder that you shouldn't invest with a rearview mirror. The chart below shows how bond yields have risen since 1977 relative to prospective returns on stocks to compensate investors for the greater volatility of bond prices and the risk that the bonds' value would be eroded by high inflation. I am convinced, however, that the world's central bankers will not allow devastating inflation to be unleashed again. If I'm right, bonds now offer unusually generous returns. And investors who share my expectation of moderate inflation in the 1990s should consider putting one-third to one-half of their portfolios into high-quality bonds.
CHART: NOT AVAILABLE CREDIT: GRAPHS AND CHARTS BY HAYES COHEN Sources: Ibbotson Associates, Young Research & Publishing CAPTION: THE SOARING SIXTIES THE SOUR SEVENTIES THE ROARING EIGHTIES THE NORMAL NINETIES
How four decades of profit compare While there are long-term patterns in stock and bond prices that serve as useful benchmarks, the biggest mistake investors can make is to assume that current trends will continue unchanged. The chart at left shows how total returns on blue-chip stocks, bonds, cash and gold compare over the past 30 years, as well as Malkiel's projected returns for those assets in the 1990s. The 1980s were a complete reversal of the 1970s. While both Standard & Poor's 500-stock index and long-term Treasury bonds underperformed riskless Treasury bills in the 1970s because of rising inflation, they clearly outstripped the returns on bills in the 1980s when inflation was falling. By contrast, gold -- the ultimate inflation hedge -- soared in the 1970s but managed only a meager 2.8% annual return in the next 10 years. For the coming decade, stocks and bonds still seem attractive, though not spectacular. At current levels, though, stocks appear a little pricey and risky. They therefore may not keep up with bonds, which are likely to be the standout choice for the 1990s. *Reflects the inflation rate. Gold was not freely traded in the U.S. during the 1960s, and prices are hard to project for the 1990s.
CHART: NOT AVAILABLE CREDIT: GRAPHS AND CHARTS BY HAYES COHEN Sources: Department of Commerce, Standard & Poor's CAPTION: Standard & Poor's 500 - stock index How stocks have performed While stocks surged in the 1980s, after inflation they are still cheaper than they were in the mid-1960s.
CHART: NOT AVAILABLE CREDIT: GRAPHS AND CHARTS BY HAYES COHEN Source: Department of Commerce CAPTION: Yields on long-term Treasury bonds How much bonds really yield Long-term yields have fallen from 14% in 1981 to 8.5% today. But real yields are still appealing.
CHART: NOT AVAILABLE CREDIT: GRAPHS AND CHARTS BY HAYES COHEN Sources: The Leuthold Group, Standard & Poor's CAPTION: Why stocks are expensive now According to three widely followed measures, stocks seem high priced. Over the past 30 years, the average price/earnings ratio of Standard & Poor's 500-stock index has ranged from 23.2 in 1987 to 6.7 in 1982. Currently the average P/E is 16.6, above the historical midpoint. In the mid-1980s, shares often traded at discounts of 20% from the values of companies' assets -- as measured by the replacement cost of those assets minus outstanding debt. Currently, however, few stocks trade at such a discount. Even by simple price-to-book-value ratios, it appears that share prices are closer to their highs than to their lows. Low yields are a sign that stocks are expensive, while high yields signal they may be cheap. With a payout of 3.4%, the S&P 500 is far closer to the 1987 low of 2.6% than the 1982 high of 6.7%. PRICE/EARNINGS RATIOS PRICE/BOOK-VALUE RATIOS DIVIDEND YIELD
CHART: NOT AVAILABLE CREDIT: GRAPHS AND CHARTS BY HAYES COHEN CAPTION: Comparing returns on stocks and bonds Until 1979, the yields on blue-chip corporate bonds were typically lower than the returns that Malkiel projects for the 30 stocks in the Dow industrials. During the past four years, though, bond yields have closed the gap. That suggests that, after risk is taken into account, high-quality bonds could outperform stocks over the next decade. The projected long-term return for the Dow industrials The yield on AA-rated, 20-year corporate bonds