2014 Q1 Newsletter

Of Risk and Bonds

Amidst a modest first quarter gain in the S&P 500, the myopic financial media repeatedly warned investors of the many risks associated with equities due to collapsing corporate earnings, fragile emerging market economies, the Russian annexation of Crimea, and most recently, flash traders that have somehow managed to rig the $15 trillion stock market.

Of particular interest to me was an article advising investors (and worse yet, retirees) to forsake the risks of equity ownership entirely in favor of the safety of bonds. He supported this ridiculous hypothesis with data on Long Term Government Bonds from June 1982 - June 2012 showing an annualized return of 10.84% versus 11.52% for the S&P 500. The author's misguided conclusion was "Long Term Government Bonds offer retirees essentially the same returns as stocks, without their inherent risks."

This advice is so dangerously misguided that I don't even know where to begin to refute it. Forget for a minute that the particular 30 year time period the author used to support his recommendation happened to be one and only 30 year time period this century that saw interest rates decimated from near 20% to 2%. And forget that real world investors incur taxes on bond interest at ordinary income tax rates that are typically twice those incurred on dividends and capital gains. Furthermore, forget that a $1MM portfolio invested in the S&P 500 over this 30 year time period would now be generating more than half of the original investment annually in dividends alone. Instead, let us refute this advice using cold, hard facts.

Investors must always consider returns within the context of the real world purchasing power they generate, i.e. net of inflation. After all, earning 2% in a year when the price of everything one needs rose by 4% amounts to a very real 2% loss in one's purchasing power. As such, below are the Real Returns for stocks and bonds during the period the author refers to, as well as for the prior 30 year period from 1952-1982:

Analyzing Real Returns during these two markedly different time periods leads us to draw some obvious conclusions:

• During periods of low inflation and plunging interest rates, bonds are capable of producing positive Real Returns.
• During periods of high inflation and rising interest rates, bonds are capable of getting absolutely clobbered. Note that the 2% annualized loss in long bonds from 1952 - 1982 would have resulted in a 50% reduction in purchasing power.
• Equities are capable of generating positive Real Returns in both environments.

Considering that ten year treasury bonds are currently yielding about half of their long term average, it is very difficult to make the case for plunging interest rates going forward. And considering the Federal Reserve is currently winding down the most accommodative monetary policy ever implemented in the history of central banking, it is even more difficult to make the case for low inflation going forward. Of course, it is impossible to predict the future. But only fools would ignore the very real possibility that investors seeking safety in bonds at today's levels may very well be disappointed for a very long time. Unfortunately, most investors, especially retirees, have no earthly clue that such a scenario is even possible.

Enclosed are hard copies of our updated SEC Disclosure Document (ADV Part 2) and Privacy Policy for 2014. If you would like an electronic cop of either or both, please feel free to contact us.

Don Davey
Senior Portfolio Manager
Disciplined Equity Management
Plan Appropriately, Invest Intelligently, Diversify Broadly, Ignore the Noise