Newsletter September 11, 2010

InvestorsFriend Inc. Newsletter September 11, 2010

Invest in Stocks or Long-Term Bonds?

Which is likely to give you the better return over the next ten years, stocks or long-term bonds?

The return from long-term bonds is easy to observe.

The return on 10-year U.S. government bonds is 2.8%. If you buy a 10-year U.S. government bond today and hold it until maturity in ten years you will earn a compounded return of 2.8% per year (before considering any Commission paid to buy and sell the bond and before deducting any income tax payable). The equivalent figure on a 10-year government of Canada bond is slightly higher at 3.0%. The return on these government bonds is known at the time of purchase. It will be 2.8%  for a U.S. ten-year bond held to maturity, no more, no less.1

What about corporate bonds? Those pay a bit more. High quality 10-year Canadian corporate bonds currently yield about 4.3%. Barring bankruptcy of the corporation, which is a low risk in regards to high quality companies with strong credit ratings, the return on these bonds, if held to maturity in ten years, will be 4.3%, no more and no less.

In contrast, the returns from holding stocks for the next ten years can only be forecast. It cannot be known with certainty. In fact, it is subject to a good deal of uncertainty.

But some educated predictions can be made regarding future stock returns.

The return from stocks will be based on dividends and, most importantly, the price the stocks can be sold for in ten years. The price that stocks can be sold for in ten years can in turn be estimated by forecasting the growth (or decline) in earnings and by forecasting the multiple to earnings at which stocks will sell.

The Toronto Stock Exchange Index currently has a dividend yield of 2.7%. The Dow Jones Industrial Average is currently yielding about 2.75% and the S&P 500 is yielding 2.1%.

We can stop right there and observe that the dividend yield alone on these large stock indexes is returning about 75 to 100% of the yield on 10- year U.S. government bonds. And about 50% of the yield on Canadian high-quality 10-year corporate bonds. Mathematically, this means that unless dividends are going to decline, stocks will not need to rise much in price over the next ten years in order to beat the return on bonds.

Imagine stocks have increased in price by just 15% ten years from now. That would be very disappointing and represents a compounded gain in price of 1.4% per year. If that happens, then stocks will (adding in dividends) have returned about the same amount as 10-year bonds.

So all that stocks have to do is increase in price by about 1.5% per year on average  and they will beat those 10-year bonds. And if stocks can manage to increase in price by 5% per year or more then their returns will about double the returns from those ten year bonds.

Right now the trailing earnings P/E ratios on the S&P 500 at 16.3 and on the DOW Jones Industrial Average at 14.2, are neither abnormally high, nor abnormally low. In this situation, we might expect stock index prices to rise roughly along with the growth in the economy. Most economist predictions call for real GDP growth of about 3% per year. Adding in inflation of 1 to 2% results in a projection that nominal GDP will grow at 4 to 5% per year. On average, earnings should grow by about the same amount. And if the P/E ratios remain about constant then the stock indexes will rise by a similar 4 to 5% per year on average.

With this outlook, stocks can be expected (but are not guaranteed) to beat today’s low bond returns quite easily over the next ten years.

Looked at another way, the earnings yield on the Toronto Stock Exchange is currently 4.9%, and the Dow earnings yield is currently 7.0% and on the S&P 500 is 6.1%. It simply seems quite logical to expect to earn more, over the next ten years, from a group of companies that are earning, on average, 4.9%, 6.1% or 7.0% on market value (and which earnings tend to grow over time) then it does from bonds with fixed returns in the 3.0% to 4.4% range.

One has to be quite pessimistic to expect that stocks will not beat these ten year bond returns. Certainly if one believes we are heading into a depression or end-of-the-financial-world-as-we-know-it scenario then one can expect stocks to trail bonds.

Warren Buffett has written about comparing expected returns from bonds and stocks.

In his 1984 letter, Buffett states:

We believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.

If an investor had been business-minded enough to think in those terms – and that was the precise reality of the bargain struck – he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards.

Today, once again investors are happily buying long-term bonds on terms that are outrageously inadequate by business standards. It’s an abomination.

I am not advising anyone to avoid all long-bonds. But I can’t justify the purchase of long-term bonds. Those with more pessimistic outlooks for the economy may be able to justify it, but I can’t.

Stock Market Valuation

You would not want to invest in stocks if they were clearly over-valued. Our very popular article that looks at the valuation of the Dow Jones Industrial Average has just been updated.

United States Dollar and Risks

Many analysts believe that the United States is hopelessly in debt and that eventually it will default on its bonds either directly or through its dollar becoming “worthless” leading to hyper inflation.

If so, then whoever it is that is lending money to the United States at an interest rate of 3.9% on a 30-year bond clearly and 2.8% on a ten-year bond “did not get the memo”. If there is a risk of hyper inflation or really almost any inflation over 1 or at most 2%, then these investors are going to regret loaning out their money at that kind of rate for 10 or 30 years.

I don’t think I am in any kind of position to be able to predict things like hyper inflation. I simply observe that the “bond market” is not fearing it.

Our Performance

This year to date the Toronto Stock Exchange index is up 3% while the Dow and the S&P 500 are about flat for the year. Meanwhile our Buys and Strong Buys are up an average of 1.8%. Our only Strong Buy rated stock at the start of 2010 was Shaw Communications, and it’s up 4.4%. These figures exclude dividends. My own portfolio is up 2.7%.

Over the longer term our Stock Picks have strongly outperformed the market.

On August 7th I and this Web Site were featured in the Edmonton Journal in a very positive way. As a result, we gained an astounding 1000 new subscribers to this free newsletter. Greetings to all the new subscribers. I believe people were attracted by both the strong long-term performance and also the honesty and lack of hype that was projected in the article. Not only did about 1000 people join this free list in response to the article, but about 150 of them have immediately joined our Paid Stock Picks Service.


Shawn Allen, President
InvestorsFriend Inc.

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1. Technically the actual return on a ten-year bond could be a little more or a little less than the current yield to maturity depending on the interest rate at which the annual interest payments received are reinvested, but that will not have a material impact given that these interest payments are small, given today’s low rates, and it would take a large change in interest rates for this factor to have much impact.

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