Why Stocks Could Outperform Bonds Over The Next Decade

``The investment world has gone from underpricing risk to overpricing it. Cash is earning close to nothing and will surely find its purchasing power eroded over time. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."-Warren Buffett, annual letter to Berkshire shareholders

Despite the surfeit of available information via cyberspace, much of these do not necessarily account for as knowledge, since pieces of information could be irrelevant or just plain rubbish or built around flawed presumptions.

In last week’s Should We Follow Wall Street?, we disputed the idea of a universally accepted technical wisdom from Wall Street.

We made as one of our example the polemics about the equity premium or the comparison of the returns of bonds versus stocks.

Nitpicking over hundreds of years of data, for us, would seem like another exercise of vanity.

Unless humanity will reach a state of human-machine convergence or Singularity soon, from which futurist Ray Kurzweil predicts that ``our intelligence will become increasingly nonbiological and trillions of times more powerful than it is today—the dawning of a new civilization that will enable us to transcend our biological limitations and amplify our creativity,” looking at an investment horizon of 100 years or more is downright impossible or impractical to put in practice.

Moreover, given the rapidly evolving dynamics, largely supported by technological innovation, such devotion to interpret a mountain of market historical data defeats Wall’s Street’s basic mantra of “past performances doesn’t guarantee future outcomes.”

So even if bonds have been proven to outperform stocks in the longest run, it doesn’t necessarily translate to the same outcome over the next coming decades.

Lastly, it’s about data mining too. Advocates of one particular cause tend to use time reference points that support their underlying bias, as different time periods yield different results.

However, over the next decade or so we believe that stocks should outperform bonds.

Here are the reasons why.

One, global government in an attempt to reflate the markets has imposed policies, such as massive stimulus spending, a cheap money environment as shown by the steepening of the yield curve [see Steepening Global Yield Curve Reflects Thriving Bubble Cycle] and quantitative easing, that has indirectly been supportive of the equity assets.

Second, under the onus of over indebtedness, afflicted governments have been tacitly inflating away these burdens through inflationary policies. And since inflation erodes a currency’s purchasing power, higher inflation thereby reduces real gains on fixed income.

Third, as governments take on more debt to substitute for declining private sector demand, inflationary policies serve as an indirect way to default on debts.

Fourth, global supply of debt will transcend available capital.

Fifth, the mercantilist inclinations of global governments will employ measures to prevent the necessary adjustments in the values of their respective domestic currency so as to protect “export markets”.

Hence, inflation will likely be a global phenomenon than one limited to debt scourged nations.

Sixth, even in the US, financial asset pricing has increasingly been influenced by inflation more than capital gains.

In fact, it is nearly catching up with dividends. [see our earlier discussion on Worth Doing: Inflation Analytics Over Traditional Fundamentalism!]

Figure 6: Economagic.com: 10 Year Treasury In A Bond Bull Market For 27 years!

Seventh, bonds have been in a bullmarket since the early 80s [see Figure 6], hence ``it would be almost impossible for bonds to generate the same amount of capital gains as they did in the past” argues Peng Chen, Ph.D., CFA, and Roger Ibbotson, Ph.D. (HT: Gully)

This suggests too that the US treasury bearmarket could likely be as long as the last bullmarket (27 years) or the previous bearmarket (30 years).

Figure 7: Manual of Ideas’ Instablog: Tobin’s Q

Lastly, in an inflationary environment the cost of replacing company’s assets would increase, hence stock prices should also adjust to reflect on this changes, based on the Tobin’s Q ratio, or a measure defined by wikipedia.org, ``comparing the market value of a company's stock with the value of a company's equity book value. The ratio was developed by James Tobin (Tobin 1969). It is calculated by dividing the market value of a company by the replacement value of the book equity.”

If the derived value is greater than one then this suggest of overvaluation [as market prices are greater than the company’s assets] and if the value is less than one then it is an indicator of undervaluation.

Notice that during the stagflationary decade of the 70s to the early 80s the Tobin’s Q had largely been undervalued or that stocks were priced below their replacement costs, although stocks and bonds had marginal differences in returns, according to Shawn Allen of Investor’s Friend ``The 20 years from 1966 through 1985 were ugly all around. Stocks came out slightly ahead but were the best of a dismal lot.”

As a caveat, since inflation impacts asset prices relatively, stocks won’t likely perform in a uniform manner and would likely be distinguished based on the industry.

So yes, like Warren Buffett, we think stocks will outperform bonds over this cycle.