(Originally published October 15, 2010)
One Friday in October, I drove down to Charlotte with Anne and a dear friend to attend a black tie dinner celebrating the 25th anniversary of the Western Carolina Chapter of the Alzheimer’s Association. Having seen my mother and a number of our clients’ lives devastated by the disease, I have volunteered to chair Greensboro’s 2011 Memory Walk and the dinner only cemented my commitment to the cause. (If you’d like to help fight this disease, you know how to find me.) The highlight of the evening was getting to meet Vera Guise, the woman from Cullowhee, NC, who 25 years ago, while caring for two Alzheimer’s afflicted parents, single-handedly founded the chapter that today provides help and hope to 50,000 families in 49 counties in western North Carolina.
The only ‘lowlight’ of the rather memorable evening was the ride down. After twenty minutes of smooth sailing, we met screeching stops, bad-tempered drivers, and hyped up kamikaze motorcycles weaving through traffic at speeds approaching the sound barrier. What should have been a pleasant hour-and-a-half trip turned into a three-hour trek. Had it not been for the good traveling company, it would have been unbearable. The interesting thing about being in a traffic jam is that there is always a tendency to pick the lane that seems to be traveling the fastest. Sometimes you’ll luck out and move along better, but more often than not, you aren’t the only driver to have that brilliant idea and the fast lane quickly grinds to a halt.
Somewhere between Salisbury and Kannapolis, I realized that the financial markets are much like a never-ending traffic jam. While one asset class moves along, others stand still. At times, all lanes move along at breakneck speed and at other times, an overturned tractor-trailer stretches across all five lanes. In the last 21 months, we’ve seen unprecedented cash flow into bond mutual funds and out of stock mutual funds. While we’ve seen plenty of lane-shifting in the past (into technology in the 90’s and real estate in the 00’s), much of that shifting was out of one fast-moving lane into another even faster lane.
The thing that makes today’s “Great Lane Change” into bonds unique is that we’re seeing “drivers” move from both the slow lane (Money Markets) and the fast lane (Stocks) into the middle lane of Bonds. The investors in Money Markets and CDs are fed up with near-zero returns and the investors in Stocks are happily taking money off the table that has seen a nice return over the last 18 months. Combine this with the great past returns of bonds (that are still, as the saying goes, no sign of future returns) and you can see the traffic patterns pretty easily.
The problem we see with continuing to add to bond positions (even, and especially, in the “safest” of these, the U.S. Treasury) is three-fold: the retail investor is rarely right, the bond lane seems to have a flashing “Road Work Ahead” sign squarely in the road, and we think high-quality dividend-paying stocks have many bond-like qualities without the same interest rate risk.
The Investor is Rarely Right
These flows show, for the most part, the decisions of retail mutual fund investors, who have been known, as a group, to buy and sell the wrong things at the wrong times. A recent study from DALBAR shows that for the last 20 years, equity returns for the S&P 500 index have been 8.35% annualized versus just 1.87% for the average investor. On the bond side, the results have been much the same; Barclay’s Bond Index rose 7.43% annually versus the average bond investor’s return of 0.77%. In other words, Joe and Jan Investor’s timing has been far from impeccable and this “Great Lane Shift” makes us suspicious.
Road Work Ahead
The chart above shows 10-year U.S. bond yields since 1798. Note that in only two other periods in our country’s history have we experienced yields this low (once in a lifetime!) It is important to remember that in the seesaw bond world, rising yields result in falling prices. If U.S. bond yields revert to 4% (where they were just 6 short months ago in April 2010!), bonds could lose nearly 10% in price, the equivalent of the next four years’ interest payments. Investors’ thirst for high quality bonds could turn out to be a very expensive form of insurance just to hedge the pain of prolonged uncertainty.
So, if the bond lane looks congested with Road Work Ahead, is there an alternate route? Let’s look at an example. Today, we can buy a Johnson & Johnson (JNJ) 10-year bond paying 2.83% yield to maturity and whose bond payments are guaranteed to grow 0% over that time. Alternatively, we could own JNJ common stock, whose latest quarterly dividend of 54 cents per share equals a 3.4% annualized yield. If the company continues to raise the dividend at just half the rate we expect, the “rent” will likely more than outpace inflation.
And while we know as well as anyone that stocks like JNJ can (and will) go down sometime in the future, we’re at a point where buying bonds at today’s prices carries near-equal risk with nowhere-near the incremental return. If inflation and interest rates revert to trend levels, an investment in JNJ bonds could impair our capital and result in diminished future purchasing power (that 10% drop mentioned above) while the stock dividends could have growth potential.
Meflation is What Matters
Last month, The Wall Street Journal’s Jason Zweig penned a piece about “Meflation”. He noted that investors put so much effort into figuring out whether we’ll see inflation or deflation and picking the right course based on the research. His thoughts were refreshing: don’t invest according to what you think will happen, rather invest according to what will affect you personally (“me”). This is the same approach we take with Bonds versus Stocks. While we’ve laid out reasons to think about not swerving broadside into the bond lane, it doesn’t mean we are avoiding the tangible safety and predictable returns of bonds. The trick is to make a sound judgment about the trip ahead and then chart an appropriate course.
The most important thing about our drive to Charlotte last Friday was not that our trip was pleasant or that we arrived before anyone else. Rather, the most important thing was that we got there safely, and after experiencing a wonderful evening, we arrived safely back home. Some terrified drivers pulled over and waited for traffic to clear. Others took the first available exit off the interstate or made a u-turn, causing us to wonder if they knew where they were going. And some switched lanes incessantly, unaware they lost about a car length with every change. Our Suburban held it in the road, adjusted to changing conditions, and we did our best to enjoy the ride.