Equity Markets
Equity markets finished the third quarter with a very strong performance in September, bringing all major categories into positive territory for the year to date (YTD).  With returns less than 4%, large-cap US and international markets are below our long-term expectations while small company stocks (+13% YTD) and real estate (+20% YTD) are above their long-term averages and making very positive contributions to diversified portfolios.

After a summer of doom and gloom reports about chances of a double-dip recession and the government debt crisis in Europe, it is a bit of a surprise to see all markets in positive territory, proving once again the value of diversification and a consistent discipline.

The Irony of Bonds
Falling interest rates have bolstered bond returns in 2010.  When rates fall, bond prices rise.  The increase in price provides an immediate boost to returns, but the lower rates mean expected future returns are lower.  So total returns for 2010 are over 7% for a bond market index fund but yield to maturity is down to 2.3%.

Is Now the Time to Buy Dividend Paying Stocks?
I keep reading articles that present dividend paying stocks as an alternative to low fixed income returns.  One author recently noted that a number of companies have a dividend rate (as a percentage of the stock price) that is half a percentage point or more higher than their ten-year bond yields.  He specifically mentioned Johnson & Johnson with a dividend yield of about 3.6% and ten-year bonds yielding about 2.9%.  “And, of course, that dividend is going to rise over time, whereas that bond payment is fixed.”

That may be true, and consistent with long-term expectations, but stocks and bonds have very different risk characteristics, and dividend paying stocks are still stocks. (See Inset on page 2 “How Volatile Are Stocks?”)

For the past five years, and even the past ten years, bonds have outperformed stocks.  We expect the opposite over the long term, and with interest rates near historically low levels, the expected returns from stocks, dividend paying or otherwise, are appealing as part of a well-diversified portfolio.

What Should We Expect From Here?
Markets have been relatively volatile and we can expect more of the same, as markets react to good and bad news about economic events.  We tend to observe less volatility when everyone agrees the economy is growing and debate centers on the rate of global economic growth.  The current debate however, about inflation or deflation, recovery or a double-dip recession, reflects a greater level of uncertainty, which is naturally reflected in greater market volatility.  (See Inset “How Volatile Are Stock Returns?”)

So, investor fear remains high amid the volatility and uncertainty.  One indication is the measure of cash flowing from stock to bond mutual funds.  Morningstar reported that bond funds grew by $168.5 billion while domestic stock funds shrank by $42.2 billion, year to date through August.  This data supports the statement of Gus Sauter, Chief Investment Officer for Vanguard.  When asked what is the greatest risk investors face today, he replied, “Not participating (in equity markets).”

The formula for success remains unchanged:  understand risk, diversify, and follow a consistent discipline.

How Volatile are Stock Returns?
It is important to remember that stock markets have always been volatile.  Looking at the S&P 500 since 1926 we observe the average monthly return at a bit less than 1% per month, but the chart below shows how much returns gyrate.  The chart also shows the much less volatile monthly returns on five-year Treasury bonds, which have an average monthly return of nearly 0.50%.Month to month, or even for a year or two, the additional risk of stocks seems unappealing compared to the meager half percent additional return.  Indeed, short-term investors have no business investing in stocks.  However, if we step back and look over a 40-year period of accumulation or retirement distribution, the extra risk is expected to pay off handsomely as illustrated in the chart below showing the growth of $1 over a 40-year period ending in each of the past five decades.Historically, stock prices have been volatile, and we should expect that to continue.