Bullish on Stocks

Last month, we brought to you a couple of articles illustrating the increased disenchantment of investors with stocks, and how more and more are seeking the perceived safety of bonds.

We believe that such investors are once again driving with their eyes set on the rearview mirror and making a terrible mistake: we feel strongly that over the next decade, not only are stocks of large companies likely to outperform bonds, but that they will also provide investors with attractive returns adjusted for inflation. In other words, now is not the time to throw in the towel on equities.

What gives us such a positive outlook? Besides what we view as low valuations for the companies currently in the portfolio (the average discount to fair value is currently greater than 40%), we bring you two bits of evidence:  1) a look at the history of stock dividend yields compared to bond yields; and 2) the history of real returns for the stock market.

For the first time in over half a century, blue chip stocks in the Dow Jones Industrial Average are yielding more than bonds. Think about that: because dividends grow over time, while coupon payments from bonds do not, the current relationship between stock and bond yields indicates that investors today are willing to pay more for a fixed stream of payments than a growing one. The reasons for this preference could be that investors believe that dividends will be reduced going forward or that bonds offer greater principal protection over the long run (or any combination thereof). 

We find the first concern unlikely to play out over the next decade considering that current profitability and dividend payouts are closer to historic lows and, therefore, are more likely to grow. As far as the protection of principal argument goes, this may be true nominally.  But at currently prevailing interest rates (the 10 year US Treasury yields 2.75%) even a modest and historically typical rate of inflation will nearly erase a bond investor's real return.  Worse yet, an above-average rate of inflation will result in a negative real return for the bond investor.  Such is the price of "security." 

Another reason we are positive with our outlook has to do with historical 10-year real (i.e., adjusted for inflation) returns for stocks. It has been well documented that the past decade was the worst in history for stocks, even worse than the Great Depression. The chart below, compiled by Doug Short (dshort.com), provides a useful historical perspective:

Pay close attention to the red line in the bottom half. 10-year annual returns adjusted for inflation have fluctuated between lows of minus 4-6% and highs of plus 16-20%. The mean appears to be around 5-6% in excess of inflation. Besides noting that returns over 10 years can experience wild differences, the other obvious reading is that the recent decade was at the bottom of the range since 1870! How likely is it that rolling 10-year returns will remain near century-long lows? At Bristlecone, we feel that it is more likely than not those 10-year returns will creep back up in coming years and that they will show some reversion to the mean.

In other words, we believe that a portfolio of select, competitively strong, large company stocks, trading at modest valuations likely offers investors a better chance of preserving the purchasing power of their assets over the next decade.  Note that we offer no prediction about the next 12 months... sorry!