April 16, 2010
Financial markets continued their winning ways in the first quarter of 2010 marking four consecutive quarters of positive stock market returns. The chart at right shows the impressive performance of small company stocks during the past three months and the fact that all major asset classes had positive returns.
The chart also shows impressive gains over the past twelve months, reminding us how dramatic the recovery has been from the depths of the financial crisis (S&P 500 up 50%). The consensus forecast a year ago was for a long, slow recovery of the world economy, which appears to be occurring. The snap-back in equity values can be attributed to a stabilization of the economy that has reduced uncertainty. No one expects a sudden jump in sales and earnings, but stock values have responded favorably as the risk of a market meltdown fades in the distance.
Can The Market Continue To Improve?
Many of us are feeling better about our nest eggs as we watch them recover much of their pre-crisis value. So how much upside remains? Unemployment remains high and sales and profits are still far from pre-crisis levels. The chart below provides an interesting perspective, showing the value of the S&P 500 index over the past 15 years, ignoring dividends. This provides a clear picture of the technology bubble and the financial crisis. Over the 15-year period the index has nearly tripled in value, but what a ride! It also shows that the 500 largest U.S. companies have, twice in the past ten years, been valued 30% above their current valuations. If we have some faith in the U.S. economy, it seems that we should be able to achieve those levels again, but through sustainable growth in sales and earnings and without the aid of an economic bubble. We are also certain to see some bumps in the road and some negative quarters along the way.
With returns that appear insignificant compared to stocks and the threat that inflation and higher interest rates will chew up bond values, why continue investing in bonds? Diversification is the key benefit of bonds, which was clearly demonstrated in 2008 when stocks were down 37% and the bond market was up 6%.
If Interest Rates Are Sure To Rise, Should We Get Out Of Bonds To Avoid Devaluation? Not necessarily, because if rates rise, a diversified bond portfolio could still perform better than cash or short-term bonds. Rising rates devalue bonds, but rates do not always rise for all bonds. The chart below shows how money market rates rose from less than 1% to over 4% between December 2003 and December 2005, and yet long-term rates actually fell. The steepness of the current yield curve reflects the expectation of increasing rates, but the increase could flatten the curve rather than result in higher yields at all maturities.
It is also worth noting that bond returns were positive in 2004 and 2005. As rising rates were devaluing bonds, interest income was sufficient to keep total returns positive.
But What If Inflation Takes Off Like It Did In The 1970s And Rates Skyrocket? Then it might make sense to look toward TIPS (Treasury Inflation Protected Securities) as a source of positive returns. The principal value of TIPS, which is paid at maturity, grows at the rate of inflation. However, this insurance against inflation is not free. If inflation turns out lower than projected, TIPS will underperform normal Treasury bonds.
In summary, bonds provide diversification and TIPS diversify the bond portfolio and provide protection from unexpected inflation. Diversification has been described as, “always owning something that you wish you didn’t own.” In 2008 we were glad to own some bonds. Over the past twelve months it would have been nice to own only stocks. Bond diversification helps to stabilize returns, and in the long run, that is a good thing.