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Sea Change?

Adam M. Grossman

A KEY CONUNDRUM FOR investors: On the one hand, the data on tactical trading are clear. Frequent portfolio shifts are a bad idea and can damage returns. On the other hand, we shouldn’t be so wedded to the status quo that we’re unwilling to ever make a change.

With this conundrum in mind, it was notable when investor and author Howard Marks declared a “sea change” in the investment landscape and recommended that investors revamp their portfolios. The sea change that Marks is referring to is the recent reversal in interest rates. In round numbers, U.S. interest rates declined by about 20 percentage points between 1980 and 2020. But after bottoming near zero, rates moved up rapidly, with the Federal Reserve’s benchmark rate now north of 5%.

To see why this change in the direction of interest rates is so important, let’s start with some background. Higher rates have lately been a boon to savers, making it easy—for the first time in a long time—to earn a meaningful return on cash and bonds. But higher rates have hurt share prices, for a few reasons.

First, higher rates make it more expensive for companies to borrow. This reduces their profits and, all things being equal, translates to lower stock prices. Second, when bond returns become relatively more attractive, some investors shift their investment dollars from stocks to bonds. At the margin, this puts downward pressure on share prices, since stocks are affected by supply and demand. Finally, because a company’s value should, in theory, reflect the present value of its future profits, higher rates translate to lower stock prices.

While share prices have recovered some of last year’s losses, Marks isn’t so sanguine about their future, and this is where he believes a sea change is underway. Stocks, Marks argues, will see more muted returns in the coming years because they won’t enjoy the tailwind of declining interest rates that had boosted returns for 40 years. Falling rates, he says, were “probably responsible for the lion’s share of investment profits made over that period.”

But going forward, Marks sees stocks facing the three headwinds described above. Bonds, on the other hand, now look comparatively more attractive. Marks points specifically to high-yield bonds, which today are paying close to 8%—not far off stocks’ 10% long-term average. For these reasons, Marks says investors should shift “a substantial portion of portfolios… perhaps the majority” over to bonds.

Usually, I agree with Marks’s recommendations. But in this case, I see things differently and wouldn’t recommend making a big shift into bonds. Why? In his memo, Marks acknowledges several ways in which his forecast might be wrong. Chief among them: Bonds, by their nature, “don’t have much potential for appreciation.” Unless it’s the deep-value end of fixed income—an area not readily accessible to individual investors—it’s hard to realize big gains with bonds. By contrast, stocks have theoretically unlimited potential for appreciation.

To better understand this difference, consider Apple. The company has more than $150 billion in bonds outstanding. What would happen if Apple developed a profitable new product? Its bonds wouldn’t gain even a sliver of value. Apple’s stockholders, on the other hand, would benefit greatly if a new product boosted revenue and profits. While Apple is a special case, this dynamic is universal and illustrates the fundamental difference between stocks and bonds. Stocks allow investors to participate in the upside of corporate innovation, while bond returns are essentially capped.

Despite stocks’ structural advantage, could Marks’s forecast still be correct? If 40 years of declining rates artificially boosted stock market returns, will future returns necessarily be more muted? On the surface, the numbers support Marks’s argument. Between 1926 and 1979, the U.S. stock market’s average annual return was 9%. But between 1980, when interest rates began to drop, and the end of last year, returns averaged a much loftier 11.5%.

These higher returns seem to support Marks’s argument, but where I would disagree is in the interpretation. While it would be nice to continue to enjoy the higher stock returns we’ve seen since 1980, that doesn’t mean the alternative is so dismal. If stock market returns reverted to their pre-1980 level of 9%, that would still beat the returns available today on bonds. That, in my view, is the comparison that’s most important.

Dimensional Fund Advisors offers another lens through which to compare stocks and bonds. Between 1926 and 2022, a dollar invested in the S&P 500 would have grown to $11,527. That same dollar would have turned into just $22 if invested in short-term bonds and $131 in long-term bonds. The comparison isn’t even close. The upshot: While bonds might be relatively more attractive today than they were in the past, the data suggest that bonds will remain relatively less attractive compared to stocks.

Jeremy Siegel, writing in his bestselling book Stocks for the Long Run, provides an even longer-term perspective. Between 1802 and 2012, stocks delivered real returns—that is, on top of inflation—of 6.6% a year. Bonds, meanwhile, returned just 3.6%. To be sure, there have been periods when bonds have outperformed stocks, but that hasn’t been the case over the long term.

A final fly in the ointment for bonds: In highlighting the attractive prospects of bonds, Marks is mainly referring to the 8% yields available today on high-yield “junk” bonds. The trouble, however, is that high-yield bonds, in my opinion, aren’t ideal for individual investors. That’s because, unlike Treasury bonds, high-yield bonds are highly correlated with stocks, with a correlation around 0.9 on a scale from -1 to 1. The implication: When stocks drop, high-yield bonds tend to drop as well.

Consider the first three months of 2020. When COVID-19 emerged, stocks fell some 21%, but Treasury bonds and other investment-grade bonds gained 2% or 3%. This is precisely what an investor would have wanted, and why a stock-bond portfolio is, in my opinion, an ideal combination. But not all bonds are the same. Because high-yield bonds are positively correlated with stocks, they dropped in value—by more than 10%—in those early months of 2020. In other words, they did the opposite of what an investor would have wanted. (You can see a comparative chart here.)

As the old adage goes, there’s no free lunch. High-yield bonds offer attractive returns today, but history suggests they’ll do little to protect a portfolio when the stock market drops. Treasurys and other investment-grade bonds, on the other hand, have low or even negative correlations with stocks and thus should provide good portfolio protection during stock market downturns. But in exchange for that increased stability, their returns pale in comparison to stocks.

Is it possible that stock returns will be lower over the next 40 years than they were over the past 40? Yes. But does that mean bonds are now the better place for the majority of your savings? I would be wary of that conclusion.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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