The bond market rules the world, revisited

The most recent issue of the Journal of Indexes (May/June 2009) contains an article entitled "Bonds: Why Bother?" by Robert Arnott.

In it, the author compares the performance of the S&P 500 total return index over the past forty years to the return of a portfolio of a constant 20-year maturity Treasury bond. Based on the results of his comparison, he concludes that the "Stocks for the Long Run" argument famously put forward by Professor Jeremy Siegel (which we have discussed in previous posts, such as this one) is fatally flawed and categorizes it as a "false dogma" and that 2008 should teach investors the "folly of relying on false dogma."

"For the long-term investor," Arnott writes, "stocks are supposed to add 5 percent per year over bonds. They don't. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market." He goes on to say, "For the long-term investor, stock markets are supposed to give us steady gains, interrupted by bear markets and occasional jolts like 1987 or 2008. The opposite -- long periods of disappointment, interrupted by some wonderful gains -- appears to be more accurate."

We disagree with Mr. Arnott's conclusion, and would caution investors that while it is true that many false dogmas that some investors relied on should be re-examined in the aftermath of 2008, there is a real danger of running off again in an equally wrong direction. We have recently written about some evidence that many investment professionals are doing just that.

In fact, we have noted earlier that after the 1973-1974 bear market, the entire investment industry went off in what we believe was a dangerously wrong direction (see for example our previous discussions in "Beware of the witch doctors of modern finance" and "Professor Amar Bhide and his praise of more primitive finance").

Investors should be cautioned that arguments for rejecting the ownership of equity shares in good businesses as the foundation of long-term wealth creation and long-term wealth preservation are equally wrong-headed.

Robert Huebscher has published a good reply to Mr. Arnott's piece entitled "Bonds for the long run? Not quite yet." In it, he notes that, although for the two 40-year periods ending in February 2009 and March 2009 the Treasury bonds Arnott used did outperform the S&P 500 total return index, those were the only two 40-year periods since 1926 in which they did so. "For all other 40-year spans, stocks beat bonds," Huebscher writes.

Huebscher notes that for the 40-year period in question, stocks have returned an average of 10.95% per year, and that until 1980 bonds returned "a stodgy 2% to 4%." Since that time, however, "bond performance has marched steadily upwards, returning a remarkable 8.79% over the 40-year period ending in March."

We would add that bond performance truly did enter a remarkable period after 1980, because the runaway inflation of the late 1970s had brought interest rates to levels investors of today can hardly imagine, and then they began to drop steadily after the Fed adopted the monetarist arguments of Milton Friedman and Anna Schwartz. That period was truly an historic period for bond owners, one that will probably never take place again (see chart above). Indeed, the fact that the 40-year bond outperformance that Arnott cites is not found for any of the other 40-year intervals in recent history underscores the conclusion that this was truly an anomalous period in financial history.

We believe that investment in bonds and other income-producing investment vehicles can be a very important part of an investor's long-term wealth building and wealth preservation strategy. We have written about this topic previously in a post entitled "The bond market rules the world." In that post, however, we noted that "ownership-based investment [such as the ownership of equity shares in growing businesses -- i.e. stocks] should form the foundation of an investor's long-term strategy" and that "income strategies can be built on top of that foundation, rather than ever being the foundation itself."

Investors should be wary of arguments that seek to invert this architecture and replace an ownership-based foundation with a debt-based one.

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For later posts on the same subject, see also:

• "A growth-based perspective on income investing" 11/15/2010.