Time to give up on bonds?

Not when the stock market is looking subdued for the future.

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I came across yet another article citing how high stock market valuations are. It uses something called Shiller’s CAPE ratio as a reason to be wary of how expensive the stock market seems to be. There are also plenty of other measures that show stock valuations are high too. Most professionals agree that those high valuations can have a deleterious effect on future returns. You can debate the merits of Shiller’s approach, but we will treat it as a reasonable although imperfect approach to measuring how expensive stocks are, and the effects on future returns we might get.

The research I will refer to today is from realinvestmentadvice.com, and was written by Michael Liebowitz, CFA. The author makes the case that stock returns are expected to be quite low over the next 10 years or so, much like most of the other commentary to be found, but he also brings to light another angle, which I will touch on below.

I think, along with many others, that these valuation measures are best used to set reasonable expectations on what stocks might return over the next decade. These valuations simply give us the odds of what stock market returns might be. And these elevated valuations and probabilities suggest that stock returns will be quite subdued. How subdued? According to Liebowitz, the odds seem to point to stock returns being in the range of 0 to 3 percent over the next decade, when adjusted for inflation. Other measures allow for somewhat higher returns, but not by much. In fairness, they could be higher, but we won’t know until later. They could also be lower. Compare Liebowitz’s estimate to the average return of 6.8 percent per year since 1870, also adjusted for inflation. Pretty subdued. Less than half the real return (adjusted for inflation) at the high end of the range stated above. Or maybe zero. Or maybe even a loss versus inflation. Nobody knows. So we go with the odds, and assume low returns in general.

The preceding discussion is a context where stock valuation is probably helpful. But what else can it do to help us understand and navigate the next decade or so? It’s clear what it possibly foretells for stocks, but what about other investments? What does it tell us about the probable returns for bonds?

Liebowitz’s work provides not only what prospective returns look like for stocks from these high valuations, which again is a viewpoint that is fairly widely held. But he also shows how bonds would be expected to perform coming from a high stock market valuation, which I think is something worth considering.

It’s an important difference, and certainly a different context. What the article goes on to show is that when stocks look this expensive, they rarely outperform a 10-year Treasury bond over the next 10 years. If things turn out to be roughly in line with Liebowitz’s analysis, then you could essentially match the return of the stock market at about half the risk in high-quality government bonds. That’s quite a tradeoff.

Where could this scenario go wrong? Well, we could have higher inflation than is expected, and bonds might disappoint. Another issue might be that we are starting from historically low interest rates on bonds, so they may not perform as well as one might expect given these valuations, and stocks outpace them enough to justify the added risk. So while we can use this kind of information to help inform us on possible outcomes, it is no perfect script that one can follow to the word.

What this all boils down to is that it might be an inopportune time to run away from bonds. And with the recent increase in interest rates and selling of bonds, this is indeed what seems to be happening. I think if you do run away from bonds, you do so at your own risk. You might be selling the investment that delivers you the best return over the next decade, when we consider the low risk you are taking.

This does not mean jettison your stocks and put it all in bonds. What it does mean is you should continue to have an allocation to bonds which is consistent with your tolerance and need for risk. Not that those returns look great, but you have to be able to take what you can get. And by keeping bonds, you may not give up as much in possible returns versus stocks as you may think. But you will most likely get lower risk overall by mixing the two, without sacrificing much in return. So take what you can get. it’s always possible stocks will do better than this analysis shows, but you can also manage your overall risk level without giving up much. Or maybe anything at all. And you can only do that by keeping your bonds. So please just keep your bonds.