July 23, 2012 Comments

As a long-term investor I really should not be concerned with daily market fluctuations. Yet it seems impossible to keep our eyes off the market. I obviously prefer my stocks to go up. I don’t mind if the general market or any stock I don’t own or have not rated as a Buy goes down. And I don’t get too upset even if the stocks I own do go down. That can be an opportunity. As long as the earnings power of the companies we own goes up, the market will eventually recognize that. Meanwhile we should use the volatility of the market to our advantage, selling high and buying low. (Most investors seem inclined to do the opposite)

As for today stocks had a down day. I added to my Bank of America position. It is a speculative stock. The price to book value ratio looks very attractive. But the ROE is still too low. If the U.S. economy continues to improve even slowly then Bank of America will do okay. But it may be a bumpy ride.

Yesterday I tried to explain the sheer lunacy of a 30-year bond rate at 2.25%.

Let me put it in perspective a different way. I explained that with a 30-year bond at 2.25%, you get your money back on average in 24 years.

This is equivalent to investing 59 cents today to receive a dollar in 24 years. Does that make any sense? This would be a return of 71% in 24 years. But that is before inflation. You would have to hope that inflation was lower than 2.25%. If inflation was 2.25% you would have traded 59 cents today for the equivalent of 59 cents after waiting 24 years. And except in certain tax free accounts you would have to pay tax on your princely gain of 2.25% per year.

And what about buying a 10-year bond that pays 1.5% like the U.S. treasury bond. That is equivalent to paying 86 cents today for a dollar to be received in 10 years (and taking the inflation risk on that). What investor would admit to taking such a deal? And yet these bonds are being traded by the hundreds of millions daily. It’s simply not rational.

I read this morning where a 2% return might not be so bad because we might get 2% deflation, for a total real return of 4%. But investing in long term bonds will be a terrible investment if it turns out inflation is positive. And you can get the benefit of deflation by simply holding cash.

If it is truly capital preservation, without risk that you seek then consider the following:

1. For periods of more than about a year there simply IS no investment that can guarantee capital preservation in real terms. Even real return bonds can’t guarantee capital preservation because the real rate of interest can rise. There is no asset, be it paper, real or hard etc. that can be guaranteed to hold its purchasing power over a period of years. Not gold, not silver, not diamonds, nor houses, nor stocks. Some of these may be more likely than not to maintain or grow purchasing power and thus preserve capital in real terms. But none are guaranteed.

2. For shorter periods such as less than a year where (let’s say) inflation is of no concern (because you are confident inflation will be tiny) cash will preserve your capital. For safety’s sake cash is normally kept in a bank account or (for large amounts) in short-term paper such as a treasury bond.

3. Over longer periods of time cash will decline in value by the amount of inflation (offset by any short-term interest you can get) or will increase in value if there is deflation. With cash you don’t have to worry about market interest rates changing. Cash does not change in value based on supply and demand. Rather its purchasing power changes only with inflation.

If it is truly capital preservation that you crave then recognize that for very short periods only cash can achieve that. ANd for longer periods recognize that guaranteed capital preservation without risk is simply not possible.

It’s hard to see a role for long-term government bonds at today’s rates of 2.25%. Why would you lock into such a paltry return which will only protect your capital if inflation is less than 2.25% per year and which will subject your asset to possible large market value drops even if it will eventually give you a set amount of nominal dollars in the end?

Stocks on average are trading at P/E’s around 14. So that is an earnings return on market value of 1/14 or 7.1%. AND the earnings are likely to grow. What is the probability that over the next 10 years a portfolio of stocks that starts out earning 7.1% (and which can reasonably be expected to grow) will fail to out-earn a bond earning a fixed 2.25%. And what is the probability of the bond outperforming over 30 years?

Yes, 30-year bonds bought back around 1980 did about equal the performance of stocks. But stocks at around 1980 had a P/E of about 10 or an earnings yield of 10%. Long term bonds (20 years) had a yield of about 12%. So yes indeed bonds did beat stocks but they started with a head start. Today stock earnings yields are about three times the bond returns. Now stock earnings are typically only partially received in cash. But the retained portion is usually invested at an average of at least 7%, and often higher. Even the cash dividends on stocks is higher than the bond yields and the dividend is expected to grow. With such a massive head start it is hard to fathom that stocks will not easily out perform bonds in the next 10, 20 and 30 years.

But, none of this implies that stocks can’t crash very hard at any time. That is always the case. With stocks, you pays your money and you takes your chances. Or go ahead and sit in cash and give up on the idea of good investment returns. Depending on your risk tolerance (both emotionally and financially) sitting in cash may be the best option for some people.

My efforts are dedicated to the more enterprising investor who is willing to make an informed (but never guaranteed) risk / reward trade-off.