November 6, 2011

Bond's 30-Year Run: Stocks Still The Better Inflation Hedge (Guest Post)

By Charles Rotblut

“In 30-Year Race, Bonds Beat Stocks,” read a headline on Blooomberg.com earlier this week.

No, you did not read that wrong. Jim Bianco, president of Bianco Research, calculated an average annual gain of 11.8% for long-term bonds. Stocks lagged with an average gain of 10.8%. This has not happened since the Civil War, when the U.S. had a very different economy.

If you thought stocks, not bonds, were the best investment vehicles for beating long-term inflation, you’re right. This is still the case. The performance record of the past 30 years reflects two different events that combined to create a favorable environment for bond prices.

The first was interest rates. Ten-year treasury bonds yielded 15.8% on September 30, 1981, according to Bianco. Earlier today, the 10-year bond yielded 2.06%. Bond prices and interest rates are inversely related, meaning that as yields fell over the past three decades, bond prices rose.

The second was the stock market. Since 1998, the S&P 500 has experienced three severe market corrections and two nasty bear markets. These events hurt the long-term record for stocks, giving bonds an edge.

I would be remiss if I didn’t mention the Federal Reserve’s role in helping bonds. Alan Greenspan kept the interest rate environment favorable for the housing bubble. Ben Bernanke is intent on keeping long-term interest rates low for the foreseeable future, as he reiterated this month.  Fed policy has helped, and continues to help, bonds.

At some point, Federal Reserve policy will have to change from trying to stimulate the economy to being more focused on controlling inflation. We don’t know when. We also don’t know to what extent interest rates, and thereby bond yields, will rise.

What history does tell us is that both stocks and bonds still play a role in your portfolio. Bond returns are uncorrelated with stock returns over the long term. This means that diversification benefits can still be realized by combining stocks and bonds. Inflation will be a threat, but then again, 30 years ago, the outlook for bonds was also uncertain.

Worried About Inflation? Consider TIPS

If the threat of future inflation has you hesitant about bonds, TIPS may be an option. Treasury Inflation-Protected Securities are U.S. government bonds whose principal is adjusted by changes in the Consumer Price Index. These adjustments cause the amount of the interest payment to rise up or down with inflation.

The Week Ahead

Next Friday is Veteran’s Day. U.S. stock exchanges will operate on normal hours, but banks and the bond markets will be closed.

Approximately 20 members of the S&P 500 will report earnings. Included in this group are Dow components Cisco Systems (CSCO) on Wednesday and Walt Disney (DIS) on Thursday.

There isn’t much economic data scheduled for next week. September wholesale trade will be published on Wednesday, October import and export prices will be published on Thursday, and the preliminary University of Michigan consumer sentiment survey will be published on Friday.

No Federal Reserve officials are currently scheduled to speak.

About The Author - Charles Rotblut, CFA is  the VP for American Association of Individual Investors AAII Journal Editor.  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here.)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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