It was last summer when we first introduced the idea that stocks were likely to provide a better total return than bonds over the course of the next decade. In doing so, it was not our intention to build a case for reducing bond allocations. Instead, we simply wanted to suggest that stocks should not be ignored, despite the fact that the previous decade had given investors numerous reasons to do so.

 

We understood that our idea was contrary to the prevailing market sentiment. The bond market was attracting record amounts of money due to its perceived safety and attractive recent returns. While it was impossible for us to know how long this trend might last, there were several factors that made it reasonable to assume it wouldn’t go on indefinitely.

 

To begin with, it was hard for us to imagine a future that did not include higher interest rates. Many developed countries had borrowed heavily and faced challenging budgetary issues. Several of the largest developing countries were experiencing rapid growth and rising inflation. In each case, market participants would be expected to push interest rates higher, even though the reasons for doing so would be different. Since bond prices move inversely to interest rates, this suggested that bond investors would face a headwind in the years ahead.

 

Second, companies had aggressively reduced costs during the recession. This meant that even a modest improvement in business conditions would likely lead to a dramatic improvement in earnings, an important determinate of stock prices. Moreover, judging by the valuations of stocks at that time, investors weren’t giving companies much credit for the earnings they did have.

 

Third, companies had been very aggressive in accumulating cash, resulting in an unprecedented level of financial strength. As confidence returned, we thought it was reasonable to expect that this cash would be redeployed into wealth-creating activities like new products, new factories or more generous dividends. In the meantime, this financial strength would provide some margin of safety.

 

Over the past twelve months, each of these factors has begun to play out. Interest rates in several parts of the world have moved higher, either due to central bank actions (e.g., China) or specific country risks (e.g., Greece). Corporate profitability has rarely been higher and a growing number of companies are redeploying their large cash balances. As a result, stocks have rallied nicely and are now more fairly valued than last summer, even after the weakness in stock prices during May and June.

 

Despite this appreciation, we continue to believe that stocks will provide a better total return than bonds for the balance of the decade. The margin of victory is likely to be determined by the interplay of two separate, but related factors: the impact of rising energy and raw material costs on corporate profitability, and the multiple that investors are willing to pay for these earnings in a rising interest rate environment.

 

With such formidable unknowns, and stock prices that are fairly valued, we think it’s only prudent to stick with the themes that have defined our general portfolio strategy over the past few years: broad diversification, high quality, reasonable expectations and patience. What this approach lacks in excitement, it should make up for by offering the prospect of capital preservation and a satisfactory return.

 

 

 

(c) Chess Financial

www.chessfinancial.com