If History Repeats, Then It's Time to Buy Bonds

 "The market narrative is obvious after a twin inflation and interest-rate shock crushed asset prices: Nothing else much matters.

The parallels from history are equally obvious. In 1973, the Arab oil embargo trashed the economy and led to sharp rate rises, while in 1980 rampant inflation worsened by another oil shock was accompanied by then-Federal Reserve Chairman Paul Volcker's aggressive rate increases. 

Sanctions on Russia were followed by the Fed's fastest rate rises since Mr. Volcker was in charge.

Yet sometimes the differences to history are as important as the similarities. Economic comparisons matter, of course, but the starting point of valuations often matters even more.

In 1973 and 1980, stocks took a long time to recover, especially after adjusting for inflation. From a January 1973 high, it took until 1985 for investors to get their money back from U.S. stocks in real terms, as measured by the MSCI USA index with dividends reinvested. In 1980, inflation was beaten and recovery was quicker, but it took until 1983 before investors who bought at that year's peak were made whole.

So far, so simple. Academics Elroy Dimson, Paul Marsh and Mike Staunton calculate U.S. stocks delivered 5.9% a year after inflation since 1970 in work for Credit Suisse. If stocks merely rack up an average performance, it will take three to four years for investors to get back to where they started last year, after inflation. That would be a decent performance by historical standards.

Here's where we come to the difference. 

In both the 1973 and 1980 falls -- and in every recession and major downturn since -- bonds far outperformed stocks. 

This time, stocks and bonds have fallen together, with the MSCI USA down 16.7% from its high in January last year, and benchmark 10-year Treasurys down 16% since then, both with income reinvested.

In the past, it took a very long time for stocks to catch up with bonds. That's because stocks were so overvalued. A bond investor was ahead for 13 years after 1973, and seven years from 1980, when using the Bloomberg Treasury index.

It might come as a surprise to those who saw the value of their Treasurys trashed by inflation last year, but from the 1973 and 1980 stock-market highs, bonds proved more resilient than stocks in both inflation shocks, albeit still falling far behind inflation.

This time it wasn't just stocks that were overvalued. The unusual thing about this bear market is that it started with bonds wildly overvalued, too.

As a result, so was pretty much everything else. The "everything bubble" burst as central banks abandoned low-for-long rates and turned from buyers of bonds to sellers, leaving investors nowhere to hide.

Financial psychologists warn that investors ought to dismiss past losses and focus purely on the future.

It doesn't matter how long it takes to make back the previous high. It matters whether stocks will go up from here, and whether they will make more than other assets, the biggest alternative being bonds. Again, the economic fundamentals matter. Will there be inflation and/or recession?

But the starting point matters at least as much. Even after their big falls, stocks still look very expensive compared with bonds. The optimism that started this year has faded, but investors continue to bet that long-run inflation will come back under control and profit margins will stay high.

And many remain wary of bonds, even as yields approach 4% on the 10-year Treasury and are above 5% on six-month bills.

The central lesson of financial history is that over the long run, U.S. stocks beat bonds. But buying stocks when they are expensive -- at 18 times estimated earnings for the next 12 months, they have rarely been pricier outside the dot-com bubble and the postpandemic boom -- is a recipe for substandard returns.

At the same time, Treasury yields are back up to decent levels. There's plenty of scope for bonds to disappoint if inflation turns out to be endemic. But at least they start out at a reasonable valuation, based on current yields.

Investors who rightly abandoned bonds when yields were stupidly low should add them back as ballast to their portfolio. This not only smooths returns, but offers a decent income along the way.

Bonds also, importantly, provide some protection against the risk that stocks aren't merely highly valued, but still overpriced." [1]

 

1. Streetwise: If History Repeats, Then It's Time to Buy Bonds
Mackintosh, James.  Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 28 Feb 2023: B.1.