Sunday, March 29, 2009


As a result of training, part of my pleasurable weekend routine is the reading of Barron’s. This week’s issue devotes a half-page to a summary of a forthcoming 17-page piece by the respected investment authority Robert D. Arnott. A longer review of the same piece is covered by John Mauldin’s weekly letter. Both articles focus on the “myth” of a 5% equity premium of stocks over bond returns, and include Arnott’s chart of bond and stock indexes. (This not the time or place to discuss the fact that there are flaws built into indexes which can lead to faulty decisions.) Arnott’s conclusions do not take into consideration either transaction costs nor the tax impacts of capital gains. These deficiencies are understandable because they are not major concerns of the large tax-deferred or tax-exempt institutions who are Arnott’s main customers. Nevertheless, the data is somewhat startling.

In the 68 years from 1803 to 1871, bond returns beat stocks. The period includes three land wars, either within our country or on its borders. Significantly, the period ended before the credit and liquidity collapse of 1873. That period has many more similarities to the present conditions than those of 1929-1933. In the 20 years between 1929 and 1949, including World War II, bonds again outperformed. Many believed that WWII was caused by the worldwide Great Depression. Almost all data is “end point determined,” i.e. if 2006 was used as an end point, a much different result would have occurred.

I come from a bias in favor of equity, and almost disregard high quality bonds in the real world as did Franz Pick, who called them “certificates of confiscation” due to their decline in purchasing power when principal is returned with less-valuable purchasing power than when it was lent. Despite my bias, I do recognize that bonds perform better than stocks in some periods. One can clearly identify with that occurrence in periods of declining equity prices, which probably happens in one in four years, often tied to the U.S. presidential election cycle. That explanation would not count for a little more than half of the period cited, 129 out of 206 years. The superiority of bonds also must include long periods of flat or trendless markets.

How should we apply this research? Arnott believes that equities are more attractive today than they have been due to their higher-than-normal yields. I would suggest one of the reasons for the higher yield is the uncertainty of many dividends. And, I may add, the long period of equity underperformance would make stocks attractive at some point.

The stock “bulls” focus on the recent stock purchases by Warren Buffet, Ken Heebner, and Jeremy Grantham. (Three disclosure points: First, I have owned Berkshire Hathaway for a number of years both personally and in a financial services hedge fund that, after fees, produced the same a less-than-stellar -32% in 2008. In addition, Ken Heebner’s CGM Focus is in a number of our managed accounts, as well as some pro bono accounts that I influence. Finally, I have known and respected Jeremy Grantham for many years.)

The appropriate term to be used is fixed income now, not bonds as we are dealing with loans, mortgages, derivatives and similar instruments. Three institutions which I serve on a pro bono basis are in the process of building up their fixed income investments. In each case, well-respected investment managers are leading the charge. They are seeking good credit managers to advise whether or not to go directly into the PPIP (the Public-Private Investment Program unveiled by the Treasury Department last Monday), or some other beneficiary of the process of supplying liquidity to an illiquid part of the market. All of these participants believe that they have at least one year to catch the built-in inflation that has been baked into the global economy by the various governments.

From my vantage point, I recognize the potential capital appreciation of fixed income. In the past, most of the institutional portfolios which I have managed or influenced have used bonds as a strategic reserve to reduce the impact of potential equity declines. Until very recently, I have favored the use of the highest possible quality money market vehicles. However, due to the protracted low interest rate environment, I have not counted on high-quality bonds to produce meaningful income.

I now am coming to the belief that we should devote some portion of our portfolio to the capital appreciation of fixed income opportunities when and if skilled managers can be found. That is now my search. Both suggestions and comments are most welcome.

1 comment:

MEA said...


As always, insightful comments on this misunderstood asset class. We concur with your assessment of the current opportunities in fixed income. Yes, it's challenging to find good managers but they're out there! Best to focus on smaller/mid-sized firms as they seem to have navigated the credit crisis far better than their larger peers.

Mark Ahern