Investors, we are told, demand a risk premium for investing in stocks rather than bonds. Without that extra return, why invest in risky stocks if you can get guaranteed returns in bonds? This week we look at a brilliantly done paper examining whether or not investors have gotten better returns from stocks over the really long run and not just the last ten years, when stocks have wandered in the wilderness.

This will not sit well with the buy and hope crowd, but the data is what the data is. Then we look at how bulls are spinning bad news into good and, if we have time, look at how you should analyze GDP numbers. Are we really down 6%? (Short answer: no.) It should make for a very interesting letter.

Why Bother With Bonds?

If stocks outperform bonds by as much as 5% over the long run then, for our truly long-term money, why should we bother with bonds? Why not just ignore the volatility and collect the increased risk premium from stocks? That is the message of those who believe in “Stocks for the Long Run” and also from those who want you to invest in their long-only mutual fund or managed account program. Indeed, it is always a good day to buy their fund.

One of my favorite analysts is my really good friend Rob Arnott. Rob is Chairman of Research Affiliates, out of Newport Beach, California, a research house which is responsible for the Fundamental Indexes which are breaking out everywhere (and which I have written about in past letters), as well as the only outside manager that PIMCO uses, for his asset allocation abilities. He has won so many industry awards and honors that I won’t take the time to mention them. In short, Rob is brilliant.

He recently sent me a research paper that will be published next month in the Journal of Indexes, entitled “Bonds: Why Bother?” The publisher of the journal, Jim Wiandt, has graciously allowed me to review it for you prior to it actually being sent out. The entire article will be available when the Journal of Indexes goes to print in late April, at www.journalofindexes.com. Qualified financial professionals can also get a free subscription there to pick up the print copy. There is some very interesting research at the website. But let’s look at a small portion of the essay. I am reducing 17 pages down to a few, so there is a lot more meat than I can cover here, but I will try and hit a few things that really struck me.

It is written into our investment truisms that investors expect their stock investments to outpace their bond investments over really long periods of time. Rob notes, and I confirm, that there are many places where investors are told that stocks have about a 5% risk premium over bonds.

By “risk premium,” we mean the forward-looking expected returns of stocks over bonds. As noted above, if you do not think stocks will outperform bonds by some reasonable margin, then you should invest in bonds. That “reasonable margin” is called the risk premium, about which there is some considerable and heated debate.

Most people would consider 40 years to be the “long run.” So, it is rather disconcerting, or shocking as Rob puts it, to find that not only have stocks not outperformed bonds for the last 40 plus years, but there has actually been a small negative risk premium.

In a footnote, Rob gets off a great shot, pointing out that the 5% risk premium seen in a lot of sales pitches is at best unreliable and is probably little more than an urban legend of the finance community.

How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009! Even worse, going back 40 years to 1969, the 20-year bond investors still win, although by a marginal amount. And that is with a very bad bond market in the ’70s.

Let’s go back to the really long run. Starting in 1802, we find that stocks have beat bonds by about 2.5%, which, compounding over two centuries, is a huge differential. But there were some periods just like the recent past where stocks did in fact not beat bonds.

Look at the following chart. It shows the cumulative relative performance of stocks over bonds for the last 207 years. What it shows is that early in the 19 century there was a period of 68 years where bonds outperformed stocks, another similar 20-year period corresponding with the Great Depression, and then the recent episode of 1968-2009.

In fact, note that stocks only marginally beat bonds for over 90 years in the 19 century. (Remember, this is not a graph of stock returns, but of how well stocks did or did not do against bonds. A chart of actual stock returns looks much, much better.

Bill Bernstein notes that in the last century, from 1901-2000, stocks rose 9.89% before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57% after inflation, giving a real yield difference of almost 5%. In the 19 century the real (inflation-adjusted) difference between stocks and bonds was only about 1.5%.

In the late ’90s, stock bulls would point out that there was no 30-year period where stocks did not beat bonds in the 20 century. The 19 century for them was meaningless, as the stock market then was small, and we were now in a modern world.

But what we had was a stock market bubble, just like in 1929, which convinced people of the superiority of stocks. And then we had the crash. Also, from 1932 to 2000 stocks beat bonds rather handily, again convincing investors that stocks were almost riskless compared to bonds. But in the aftermath of the bubble, yields on stocks dropped to 1%, compared to 6% in bonds. If you assumed that investors wanted a 5% risk premium, then that means they were expecting to get a compound 10% going forward from stocks. Instead, they have seen their long-term stock portfolios collapse anywhere from 40-70%, depending on which index you use.

So what is the actual risk premium? Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point. Their conclusion was that the risk premium seems to be 2.5%. Arnott writes:

“My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5% equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history’s 2.5 percentage point excess return or the five percent premium that most investors expect?

“As Peter Bernstein and I suggested in 2002, it’s hard to construct a scenario which delivers a five percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day.”

One other quick point from this paper. Just as capitalization-weighted indexes will tend to emphasize the larger stocks, many bond indexes have the same problem, in that they will overweight large bond issuers. At one point in 2001, Argentina was 20% of the Emerging Market Bond Index, simply because they issued too many bonds. If you bought the index, you had large losses. The same with the recent high-yield index which had 12% devoted to GM and Ford. In general, I do not like bond index funds, and this is just one more reason to eschew them.

So Then, Bonds for the Long Run?

Let me be clear here. I am not saying you should put your portfolio in 20-year bonds, or that I even expect 20-year bonds to outperform stocks over the next 20 years. Far from it! The lesson here is to be very careful of geeks bearing charts and graphs (it will be a challenge for my Chinese translator to translate that pun!). Very often, they are designed with biases within them that may not even be apparent to the person who created them.

Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, “I have students of mine – PhDs – going around the country telling people it’s a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe.”

When someone tells you that stocks always beat bonds, or that stocks go up in the long run, they have not done their homework. At best, they are parroting bad research that makes their case, or they are simply trying to sell you something.

As I point out over and over, the long-run, 20-year returns you will get on your stock portfolios are VERY highly correlated with the valuations of the stock market at the time you invest. That is one reason why I contend that you can roughly time the stock market.

Valuations matter, as I wrote for many chapters in Bull’s Eye Investing, where I suggested in 2003 that we were in a long-term secular bear market and that stocks would be a difficult place to be in the coming decade, based on valuations. I looked foolish in 2006 and most of 2007. Pundits on TV talked about a new bull market. But valuations were at nosebleed levels. And now?

I have been doing a lot of interviews with the press, with them wanting to know if I think this is the start of a new bull market. There are a lot of pundits on TV and in the press who think so. I also notice that many of them run mutual funds or long-only investment programs. What are they going to do, go on TV and say, “Sell my fund”? And get to keep their jobs?

Am I accusing them of being insincere? Maybe a few of them, but most have a built-in bias that points them to the positive news that would make their fund (finally!) perform. And believe me, I can empathize. It is part of the human condition. But you just need to keep that in mind when you are thinking about investing in a new fund, or rethinking your own portfolio.

P/E Ratios at 200? Really?

Just for fun, when I was interviewing with the New York Times today, I went to the S&P web site and looked at the earnings for the S&P 500. It’s ugly. The as-reported loss for the S&P 500 for the 4 quarter was $23.16 a share. This is the first reported quarterly loss in history. That almost wipes out the expected earnings for the next three quarters. For the trailing 12 months the P/E ratio, as of the end of the second quarter, is 199.97. Close enough to 200 for government work.

But it gets worse. The expected P/E ratio for the end of the third quarter is (drum roll, please) 258! However, taking the loss of the fourth quarter off the trailing returns allows us to get back to an estimated P/E of 23 by the end of 2009. The problem is that you have to believe the estimates, which I have shown are repeatedly being lowered each quarter, and which I expect to be lowered by at least another 25% in the coming months.

Now, much of that loss is coming from the financials, which showed staggering write-offs of $101 billion, $28 billion coming from (no surprise) AIG alone. Sales across the board are down almost 9%, with 290 companies reporting lower sales.

This quarter the estimated consensus GDP is somewhere between down 5% to down 7%. Last quarter we were down an annualized 6.3%. That would be two ugly quarters back to back. It is hard to believe earnings for nonfinancial companies are going to be all that much better.

Side note: The economy did not contract at 6.3% in the 4 quarter. That is an annualized number. The quarter actually contracted at about 1.6%. If we go a whole year with a 6% contraction, that would be truly horrendous. We would blow right on through 10% unemployment. While it is possible, we should start to see somewhat better numbers in the second half of the year, although I still think they will be negative.

Mark-to-Market Slip Slides Away

But it is quite possible that the financial stocks see an improvement in earnings this quarter. The US Financial Accounting Standards Board (FASB) changed the mark-to-market rules last week, which many (including your humble analyst) thought was needed. First, they suspended the mark-to-market rules for assets in distressed markets. Second, they widened the definition of “temporary” impairments of troubled assets, which will “allow banks to write up the value of some troubled assets if these have been hit by falling markets without (yet) suffering any significant credit losses.” (www.gavekal.com)

Here’s the important part. The board decided to make the new changes effective immediately, prior to full board approval on April 2.

As my friend Charles Gave noted, this will allow banks to write up their paper, and it happens before Treasury Secretary Tim Geithner starts putting taxpayer money at risk. Expect to see a pop in valuations. It will be interesting to see if Citi and B of A post profits this quarter.

(I should note that the International Accounting Standards Board sent out a scathing press release. I guess from that we should assume that European banks will not be so fortunate as their US counterparts.)

In theory, as I understand it, the information will still be there, but the way it will be recorded will not be reflected in the profit and loss statement. I understand that this is a very controversial proposal, and I expect many readers will disagree. The key is whether or not the information is available to investors and how the proposals are put into actual practice. If there is abuse, and regulators should be all over this, then the old rules must quickly go back into place.

This could put some strength back into financials, at least until the commercial mortgage and credit card problems start having to be written off. At the least, it could make for another solid rise in the stock market until we start to get what I expect to be very bad 1 and 2 quarter earnings.

Housing Sales Improve? Not Hardly

I opened the Wall Street Journal and read that new home sales were up in February. Bloomberg reported that sales were “unexpectedly” up by 4.7%. I was intrigued, so I went to the data. As it turns out, sales were down 41% year over year, but up slightly from January.

But if you look at the data series, there was nothing unexpected about it. For years on end, February sales are up over January. It seems we like to buy homes in the spring and summer and then sales fall off in the fall and winter. It is a very seasonal thing. If you use the seasonally adjusted numbers, you find sales were down 2.9% instead of up 4.7%. But the media reports the positive number. Interestingly, they report the seasonally adjusted numbers for initial claims, which have been a lot better than the actual numbers. Not that they are looking to just report positive news, you understand.

Plus, as my friend Barry Ritholtz points out, the 4.7% rise was “plus or minus 18.3%”. That means sales could have risen as much as 23% or dropped 13%. We won’t know for awhile until we get real numbers and not estimates. Hanging your outlook for the economy or the housing market on one-month estimates is an exercise in futility, and could come back to embarrass you.

But that brings up my final point tonight, and that is how data gets revised by the various government agencies. Typically with these government statistics, you get a preliminary number, which is a guess based on past trends, and then as time goes along that data is revised. In recessions like we are in now the revisions are almost always negative.

There is no conspiracy here. The people who work in the government offices have to create a model to make estimates. Each data series, whether new home sales, employment, or durable goods sales, etc., has its own unique sets of characteristics. The estimates are based on past historical performance. There is really no other way to do it.

So, past performance in a recession suggests higher estimates than what really happens. Then, the numbers in the following months are revised downward as actual numbers are obtained. But the estimates in the current months are still too high. That makes the comparisons generally favorable, at least for one month. And the media and the bulls leap all over the “data,” and some silly economist goes on TV or in the press and says something like, “This is a sign that things are stabilizing.” It drives me nuts.

Ignore month-to-month estimated data. The key thing to look for is the direction of the revisions. If they are down, as they have been for over a year, then that is a bad sign. Further, one month’s estimates are just noise. Look at the year-over-year numbers. When the direction of the revisions is positive and the year-over-year numbers are starting to stabilize, then we will know things are starting to turn around.

Source: Why Bother With Bonds?

In addition, the wealth effect is a brand of self-fulfilling prophecy, which makes it even more powerful…

By investing in stocks that go up, we have more wealth.  Having more wealth causes us to go out and spend.  That spending, in turn, causes the economy to grow.  Economic growth then leads to better times for companies which, in turn, lead to higher stock prices.

Unfortunately, the power of the wealth effect works in reverse as well…

When we see our stock portfolios getting hammered, we feel a lot less wealthy.  That loss of wealth causes us to pull back on spending.  Less spending means slower economic growth, which is lousy for companies.  Poor outlooks for companies mean lower stock prices.

And declining wealth isn’t limited to stocks.  Take a look at this chart of real estate prices…

As you can see from this graph, the year-over-year change in home values — indicated by the dark solid line — began to slow around the beginning of 2006.  But economic growth — indicated by the red dashed line — didn’t begin to slow until the middle of 2008.

In other words, the wealth effect in real estate wore off long before the economy began to sputter.  In this case, the declining value in real estate was a huge leading indicator of poor economic activity to come.

In fact, changes in just about any asset — from stocks to houses to commodities — can cause their owners to adjust their spending habits.  And those spending adjustments are going to happen after the owners’ assets take a hit.  And that makes them a great predictor of where things are headed.

I’ve told my readers time and time again that a recovery in real estate prices — and stability in the real estate market — is likely going to be one of the biggest pluses for a stabilized economy and higher stock market values.  Real estate got us into this mess and it’s going to get us out.

Using These Leading Indicators for Profit

So, how can you make money off the predictive abilities of the stock market and other asset classes?

Simple.  While others are waiting for the big economic indicators — such as solid growth, the labor market, and the credit crisis — to get back on their feet, you can slip into key investments long before anybody else gets wind. The markets are telling us loud and clear patience will be rewarded.

Source: Profiting from the Wealth Effect

This from Investor’s Daily Edge:

“Fear frustration; Some Call it Quits,” a recent Wall Street Journal article, unknowingly summarizes what I have been saying for a long, long time.

The article is a short list of people who have thrown in the towel on the stock market. In every instance, the people described themselves as having everything or most of their money in the stock market.

A formula for disaster.

All of the people were professionals, all were successful, or sounded so from the description of them, and all must try, very hard, to ignore all the good advice that’s out there about how to invest your money.

After many years of trying to get investors to listen to good advice, I know it’s a waste of time to say this again, but you cannot have all your money in stocks. In fact, I left the brokerage business because I was sick of my clients ignoring what I told them to do and then blaming me because they were losing money. Here we go again.

It is financial suicide to invest only in stock.

Here’s one of the saddest stories I know about learning this lesson the hard way.

Paul, a former client of mine, just retired from a Fortune 500 company with a huge stock, stock option and 401K-rollover portfolio. This guy was the poster child for how to do your retirement planning right, around $4 million.

He took his entire 401K and rolled it over into some great mutual funds. Good move, he didn’t want to be bothered with the day-to-day stuff and knew this particular group very well. He also understood the fee structure and was ok with it. This portion was about 25 percent of his entire net worth.

The rest of his money was in stock options and stock in his former company, one that he rightfully held close to heart. He credited this company with everything he had.

Two problems that are common to many retirees: one, he had too much in this wonderful company. Investments are not collectables or mementos. Paul refused to accept this.

Two, he had everything in stock. Despite my best efforts, he refused to budge from his positions. When I first met with him, his company stock was at 94. Within three years, it was at 12. That’s an 87 percent drop in value. Three fourths of his total worth dropped 87 percent.

Leaving yourself open to the full brunt of the stock market will always have the same outcome.

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INTERNAL ENDORSEMENT Stop Playing the Stock Market Lottery! In the ongoing destruction of the capital markets, no haven is safe. Gold… down. Blue chips… down. Utilities… down. Consumer staples… down. Cash? Well, maybe for a little while, but we all know the dollar is doomed. Why risk your precious funds in the stock market lottery? Did you know you can make stock market returns… without stock market risk? You can! And there has never been a better time than RIGHT NOW for this investment…

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The past six months should be enough to prove to you that the stock market, while it has great long-term returns, is a risky proposition. There are techniques that if used properly will reduce that risk, but can’t ever eliminate it. Not diversifying properly in stocks, bonds and cash, as everyone now knows, is as close to a guaranteed loss as you get in this business.

Investors have severe tunnel vision and an unwillingness to allow for failure in their investment planning, or lack of planning. If you do not plan for the type of market we are in now, you will not survive.

There have been six different “end of the world markets” since I have been investing and working in the investment industry. Every one came after a period of crazy increases in real estate and/or stocks. It is the nature of the beast.

In case you haven’t figured it out yet, there will be another market just like this one; maybe worse, it is how the market works. Call it financial selection, market cycles or just craziness, but you must plan for the next inevitable crash or be a victim again.

How do you survive these killer markets? Diversify with stocks, bonds and cash investments, use reliable research, avoid listening to conversations about investing at parties, and stick with the tried and true. This advice may seem boring and nonproductive at times, but it is the only way I have found to be there to fight another day.

Source: A Survivor of the “End Of The World Market”

These problems should be stated in financial reports. But sometimes they are hidden in plain sight.  A bit of dubious padding in pension plan earnings projections can neatly camouflage millions in shortfall.

By the way—even if you are not buying dozens of stocks for their dividends, this is something good to know. It will help you evaluate those slick plans that brokers, bankers and insurance salesmen hold out to you when you take out life insurance, buy an annuity, set up a 401(k) or do any long-term planning yourself.

Let’s start with a choice: Which would you rather have? $311.80 today to put in a 20-year bond that pays 6% a year? Or would you rather have $1,000 on Nov. 13, 2028?

They are the same. The $1000 is the “future value” of taking $311 today and investing it for 6% per annum for 20 years.

Or to reverse the order, assuming 6% a year return, $214 is the “present value” of $1000 in 2028.

And the 6% assumption? That is the “discount rate.”

The problem with Lockheed Martin and several other companies is that the potential for big pension shortfalls is craftily understated in the discount rates they use in their projections. Lockheed has been using a discount rate of 7.5% for its pension plan returns.

Is that reasonable? No way! Nor should you accept a rate like that in an annuity or life insurance plan’s projections.

First of all, a pension plan should be conservative. It should hold bonds along with blue-chip stocks, and bonds do not pay anything near 7.5% unless they are of poor credit quality and highly risky.

For reality, we’ll go to the guidelines Charles Schwab has published—a 20-year average return for large-cap stocks is 8.2%, and for bonds it’s 4%. If the pension fund is half stocks and half bonds, a reasonable discount rate would be 6.1%. In truth, the balance for pension funds today according to Watson Wyatt and several other firms is 60% stocks. With a 60-40 ratio (bonds to stocks), the discount rate should be 6.5%.

Jiggling with this number makes a huge difference. A million dollars worth of obligation in 20 years can be fully covered with $235,000 in the pension plan today if it really can average a 7.5% return. But if the proper discount rate is only 6.5%, then the fund should have $283,000 in it. That’s 20% more money.

On top of this, many pension fund managers have been switching to more bonds in the past year. If the ratio turns back to 60% bonds rather than 60% stocks, the discount rate should fall to 5.7%, and Lockheed’s pension fund would need 40% more money in it today than it would at a 7.5% discount rate. Ditto any other companies using high discount rates.

This isn’t hard to check. It’s all in a company’s annual report, and often in the quarterly reports. If a company says that it needs to add to its pension fund, or is barely covered, take a second look at the discount rate it is using to be sure it is stating the full measure of the problem.

And you can tell your broker, banker, and insurance salesman to use a reasonable rate in his projections the next time you’re doing some financial planning, too.

Source: Pension Problems Part II

This from Investor’s Daily Edge:

Reacting to market moves guarantees you will be on the losing end of the equation. Jumping in and out of investments as the market swings up and down is the absolute worst way to invest. It amounts to market timing with a broken clock.

Sometime around the late eighties, a real brain found a way to quantify what we in the investment business had been recommending for many years, a balanced portfolio. He called it asset allocation.

What asset allocation did for investors is to prove, once and for all, that investing over many asset classes, and leaving it alone, will make more money than putting all your eggs in one basket, or trying to time the market.

Essentially, a balanced portfolio, or asset allocation, means you don’t have all your money in one asset class. You spread it around over stocks, bonds, gold, cash, etc.

How much you put in each category is directly related to your age or your ability to assume risk, which goes down as you age.

In my experience, investors usually ignore this advice. The urge to get rich quickly is too great. But, the fact remains; you will make more money if you spread your risk around.

The market’s insanity over the past year was driving many investors to gold and cash, or money markets. People who would never have considered gold were pouring money into it. All they were doing was shifting the risk from equities to another investment class. And now that gold has fallen over 20 percent in the last four months, they have jumped off that ship too.  This is not a solution. This is another problem waiting to happen.

This type of activity is called, “detaching from fundamentals.” Everyone has forgotten everything we know about the markets and has just started following the noise of the herd in front of them.

In the ongoing destruction of the capital markets, no haven is safe. Gold… down. Blue chips… down. Utilities… down. Consumer staples… down. Cash? Well, maybe for a little while, but we all know the dollar is doomed.

As the markets recover, and they will, the same investors will run back into stocks long after they have been fully priced. Essentially, people are throwing money at the back of the money train. Too late!

As I pound the desk every week pushing you to look at bonds, it is with the assumption that you are using a balanced approach. That is, you have the appropriate percentage of stocks to bonds for your age.

The formula is very simple, the discipline and patience to make it work is not. Subtract your age from 100. The remainder is what you should have in stock; the balance should be in bonds, or other low risk investments. As you get older, the percentage in bonds should increase, a lot.

Here’s the problem. The get-rich-quick urge kicks in for just about everyone and no one is able to see beyond the end of his or her nose. The best advice available is thrown out the window and time horizons are about six days.

The reverse is also true. You can never have all your money in bonds. As the market churns out the timid it may seem plausible to think, “I will never invest in stocks again.”…

I will never recommend a portfolio invested entirely in bonds.

From an inflation standpoint, it is not recommended, but that’s another article.

Go back over your accounts for the past few years. I guarantee if you work a reasonable return for an appropriate percentage of bonds into the problem, you would have made more money in a balanced approach than in the get rich quick method.

If nothing else, bonds will give you a steady return on a portion of your portfolio when the markets are flat or down, which is most of the time. This investing thing is as much about finesse as information. Patience plays a big part in it as well.

While the markets spin their wheels, take a step back and evaluate what and how you have been doing things for the past few years. From here, it can only get better.

Keep your powder dry.

Source: A Balanced Approach