After Tuesday's Fed announcement, CNBC hosted a discussion that included Bill Gross, co-CIO of PIMCO, and David Kelly, Chief Market Strategist for J.P. Morgan Funds. As one might expect from the Chief Market Strategist of a major financial institution, David Kelly is bullish on equities, advising investors to be overweight stocks. He also advised being underweight fixed income.
Mr. Kelly is certainly entitled to his opinion, and I am sure there are many strong counterarguments to his point of view. Rather than commencing a bull versus bear debate with this article, I would instead like to focus on Mr. Kelly's claim that "being overweight equities relative to fixed income has worked over the last two years" and that he thinks "it will work going forward." While we could certainly debate whether past performance has any role in determining future returns, I would like to focus on what I believe Mr. Kelly's underlying message was: stocks outperformed bonds over the past two years.
To make things more relevant to investors, for the purposes of this article, I would like to focus on returns using ETFs, investment products that investors actually purchase, as opposed to indices such as the S&P 500, or even individual bonds, which aren't as widely purchased by individual investors. When quoting returns including distributions, I assume a cash payout rather than reinvestment of the distribution.
Over the past two years, the popular ETF for the S&P 500, SPY, is up 21.28% excluding distributions. Including distributions, SPY is up 25.47% during that time.
An ETF measuring the performance of the high-yield corporate bond market, HYG, is up just 3.70% in two years, excluding distributions. However, when including its monthly payouts, the two year performance goes to 19.48%.
In terms of the investment grade corporate bond market, LQD is an ETF widely used by investors. Over the past two years, this ETF is up 9.56% excluding distributions. When factoring in its monthly distributions, LQD's two year return rises to 19.16%.
Finally, TLT, an ETF that holds Treasury bonds with more than 20 years to maturity, is up 26.06% over the past two years, excluding distributions. When including its monthly distributions, TLT's return is 34.76% in two years.
As you can see, among SPY, HYG, LQD, and TLT, the winner is the investment the majority of pundits love to hate, Treasury bonds. As Bill Gross noted during his aforementioned CNBC interview, central banks are the place "where bad bonds go to die." This may be true, but thanks to various Fed operations, those bad bonds have outperformed what is perhaps the most popular equities index, the S&P 500, over the past couple years.
A favorite saying among equity investors is "Don't fight the Fed." Perhaps investors who favor long-term short positions in Treasuries, outside of the typical seasonal declines (like we are experiencing now), should also keep this mantra in mind.
I recognize that, depending on how a portfolio is allocated, an investor might be able to claim that equities, rather than fixed income, were indeed the place to be over the past two years. For instance, with price appreciation alone, the Nasdaq 100's popular ETF, QQQ, has outperformed all the previously mentioned ETFs. Furthermore, there are most likely many individual stocks and individual bonds that have outperformed major equity and fixed income indices over the past two years.
Moreover, since diversification is widely preached by the investment community, one cannot fairly claim equities in general were a better investment than fixed income without also looking at broad international equity indices. Two exchange-traded funds, EFA and EEM, represent the MSCI EAFE Index and the MSCI Emerging Markets Index. EAFE stands for Europe, Australasia, and the Far East and includes countries such as Japan, France, and Germany. The Emerging Markets Index includes countries such as China, Brazil, and India.
Over the past two years, EFA has returned a negative 0.31% excluding distributions and just 5.31% including distributions. EEM has returned 8.33% excluding distributions and 11.87% including distributions. Clearly, an equity portfolio focused on these international equity indices, or even with just a modest weighting in these indices, would not have outperformed many fixed income portfolios over the past two years.
In closing, there are a few things worth mentioning in regard to stocks outperforming bonds:
First, past returns are not indicative of future returns. Investors can cherry pick all sorts of time frames in an attempt to make their case for being bullish or bearish appear more convincing. However, what matters most is how your portfolio will perform going forward.
At 1,395.95 on the S&P 500, are you convinced you will make more money investing in funds that track that index over whatever your time frame is than investing in high-yield debt, investment grade bonds, various commodities, international stocks, other U.S. equity indices, or even Treasuries? Also, don't assume your portfolio's allocation to equities will track a different portfolio with equities exposure. The same goes for fixed income, commodities, or any other asset you invest in. Blanket statements such as "equities outperformed fixed income" or "equities will outperform fixed income" should be taken with a grain of salt.
Second, focus on what's relative to you. In other words, when deciding whether to overweight or underweight one asset class or another, think about how your portfolio is allocated within that asset class. If your equity mix favors international equities, you need to think about how international equities will perform going forward. If your equity allocation is entirely in the Dow Jones Industrial Average (DIA), you will need to think through your expectations for future returns from recent price levels.
Third, in further expanding upon what's relative to you, keep in mind that timing matters. When thinking about the possibility of achieving the types of future returns often claimed by financial pundits (directly claimed and/or indirectly implied), don't forget to consider the manner in which you invest. For instance, do you invest your money on a set schedule, say, every two weeks (or on pay day) through a retirement portfolio? If so, given that equity markets generally spend more time going higher than going lower, you will likely be purchasing at ever-higher prices, thereby raising your cost basis over time.
Therefore, you can completely ignore the fact that the S&P 500, Dow Jones Industrial Average, and Nasdaq have more than doubled since their March 2009 bottoms. While it certainly makes for exciting headlines, it distracts from the actual situation many investors putting money into financial markets via 401ks find themselves in. Unless you invested all your equity allocation at the same point in time (and using the same allocation) chosen by pundits to make equities or any other asset class appear superior to a different financial asset, your returns will not be the same.
In fact, if the 401k investor spends some time working through the return on invested money over time rather than simply looking at balances being cushioned by new money continually flowing into the portfolio, that investor might be surprised by just how much he or she will have underperformed his or her expectations over time.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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