IN THE LATE 1990S, the equity culture reigned supreme. Employees wanted stock options, CEOs got ‘em by the boatload, and nothing seemed more lucrative than owning a piece of corporate America.
While the market has swooned, the public fascination with stocks as an asset class has barely budged. Even after another tough year in equities, by and large, stock ownership is still seen as the golden goose. Fund flows have slowed, but make no mistake: The herd is still in stocks.
Meanwhile, precious few have any indication of what’s been going on in the bond market, which continues an unprecedented bull run. Yes, the stock market has rallied from the lows of late July, but I would suggest the huge move we’ve seen in bond prices is the real capital-markets story since last Sept. 11.
As regular readers of this column know, I first started talking about bonds and the importance of portfolio income more than a year ago. Yet even given the dramatic outperformance of fixed-income securities since then, most investors are still apathetic at best. Even the recent introduction of bond ETFs hasn’t encouraged a more active approach to this oft-misunderstood asset class.
Granted, the limited return of bonds seems unglamorous compared with the potentially unlimited upside of stocks. But, truth be told, bonds are where the real power is. Why’s that? While shareholders technically own the company, their ownership claim comes after that of bondholders.
If bonds seem expensive relative to stocks these days, it’s probably because we’ve become accustomed to the notion that bonds should yield more than stocks.
But it might surprise you to learn that during the early part of last century, the yield on stocks was substantially greater than that of bonds. From 1925 to 1955, the dividend yield on the Standard & Poor’s 500 averaged well in excess of 4%, more than double that of long-term government bonds. It was only in the late 1990s that yields began to crash the 3%, 2% and 1% levels, with interest income and dividend yield being replaced by an emphasis on capital gains.
In the old days, the notion was that stockholders needed to be compensated by a fatter dividend to account for the risk associated with a lesser claim on a company’s assets. And while I’m no economist, it does stand to reason that bonds should yield less than stocks because a bond is, by definition, a superior claim on a company’s assets. That’s why the seemingly high prices of bonds these days don’t bother me at all.
When you consider recent events like the WorldCom (WCOEQ) debacle and the Enron (ENRNQ) implosion, you can appreciate my logic. When a company fails, bondholders might get at least some of their money out. Stockholders get left holding the bag, which is usually empty.
Yet even given the huge losses in stocks and a mad run in bonds, the 10-year Treasury note is still yielding roughly double the yield on stocks. To me, that’s an opportunity too good to pass up in this climate.
Traders focused on absolute return should be constantly evaluating the relative merits of each asset class. After all, you want to buy what’s in fashion, not what’s in the history books. And while the huge run in bonds and correspondingly low level of interest rates might give one the feeling they’re getting in at the top, I’m still buying bonds.
In the final analysis, while nobody knows what’s going to happen next week, the trend is always your friend. From an asset-allocation perspective, bonds might feel expensive at current levels, but history could prove them to be darn cheap.
– Originally on Sep 09, 2002 by Jonathan Hoenig
