With the S&P 500 having posted a 60+% gain between March 9 and October 19, many people have begun to wonder whether stocks will continue to be a better bet than bonds when this rapid rally slows. Many sectors of the bond market have rallied significantly also. So what is the better bet going forward?
Consider this conclusion to an article titled Don’t Give Up on Stocks Just Yet — Bonds have had a good run for 40 years but it’s unlikely they’ll maintain their pace relative to stocks by Roger Ibbotson and Peng Chen of research firm Ibbotson Associates.
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Bonds not only have outperformed stocks by a large margin over the past year because of the financial crisis, but they also roughly matched stocks over the past 40 years. Will bonds continue to outperform?
Upon closer examination, we show that stock returns over the past 40 years were virtually in line with the long-term historical average. On the other hand, bond returns were not only much higher than their historical averages, but also higher than their current yields. This high bond return is due to higher interest rates in the 1970s and a subsequent declining interest-rate environment. This scenario for bonds is very unlikely to repeat in the future, given today’s low-interest rate environment. Investors hoping that bonds will outperform in the coming years will likely be disappointed.
Stocks tend to outperform bonds over time but are much more risky, even over longer periods. Bonds can outperform stocks over a long period, but investors need almost perfect timing to get in and out of the market to realize such returns. We believe the right strategy is to follow a disciplined asset-allocation policy that considers the return and risk trade-offs by taking advantage of the diversification benefits between stocks and bonds over time.
As Warren Buffett wrote in his 2009 annual shareholder letter: “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”
- Morningstar Advisor, October/November 2009
