We first published this in 2014, but decided to republish it today given the cover story of Barron’s that reads “The Machine Driven Market,” which intuitively means the era of those machine driven models is nigh. I like this story.
Picture this: You’re an investor starting out in the 1940s after World War II came to an end. Your own experience and contemporary history of the stock market would have taught you that bonds were the safer and the superior asset class for the long term. Verily, Wall Street history, at the time, showed the rate of return on bonds had matched stock returns over the previous 70 years with far less volatility and risk! That is a longer track record than the Ibbotson memory bank, which every bull snorts about to prove that stocks are the best asset allocation for investors. Moreover, there was always the horrible memory of the Great Crash to humble any upstart who dared to say, “This time is different.”
No wonder this unforgettable and painfully learned experience spawned a generation which developed the accepted market model that whenever the dividend yield on stocks approached bond yields equities become risky. The savvy seers of the time built their investing models, and their Wall Street careers, on giving market advice based on that stock-dividend, bond-yield relationship. Indeed, until 1958 stocks generally continued said relationship, providing higher dividend yields than the interest rate return on bonds.
Then came 1958 and the dividend yield on the major equity indices slipped below the interest rate of bonds. The pundits of the time rushed to turn cautious to bearish, warning stocks were becoming overvalued and risky. No wonder, their own shared memory, and their entire investing history, proved this to be true. After all, stocks were already risker and legally junior to bonds, providing no promise of a return of capital. So when stock yields went below bond yields – look out! It had always worked before.
But, “this time was different.” Their models didn’t seem to work. Stocks kept going higher and the gap between the current return for stocks versus bonds got larger and larger. Shocking the once savvy crowd, stocks leaped some 60% in real terms in the ten years after 1958, up through 1966. As the market went higher and higher during those eight years, some of the once expert market forecasters turned even more bearish. Now their once loyal listeners tuned them out, calling them “stopped clocks!”