Buy Stocks to Prosper. Buy Bonds to Sleep at Night.
Do what it takes to stay invested in the stock market, our columnist says. Government bonds may help, even if they look unappealing now.,
If you have kept money in the stock market consistently over the last few years, congratulations.
The odds are that, after enduring terrible market declines early in the pandemic, your stock stash has grown magnificently.
This calendar year alone, the S&P 500 has risen 25 percent. Scores of stocks have gone through the roof: Devon Energy was up 182 percent through Thursday, Bath & Body Works was up 161 percent, and Marathon Oil was up 142 percent, just to name a few. The shares of roughly 80 companies in that benchmark index have risen more than 50 percent in 2021.
What’s more, the market has been rising for years: more than 16 percent in 2020 and 28 percent in 2019. In the 20 years through Wednesday, the S&P 500 has returned 9.5 percent annualized, including dividends — a cumulative gain of more than 500 percent, according to Bloomberg. Clearly, most stock investors have ample reasons for celebration.
Not so for bond investors. Bond prices have declined this year, punished by low yields and high inflation. Unlike stocks, which are inherently risky and can theoretically fall in value all the way to zero, bonds, especially U.S. government bonds, will repay their principal in full, and their prices are far more stable than stocks’. That stability may be bonds’ greatest appeal.
But when you adjust current bond yields for inflation, they turn negative. (Treasury Inflation-Protected Securities, known as TIPS, do match inflation, but provide no more than that.)
Stocks, in short, have been great lately, and bonds have been a drag on portfolios. Given those facts, you may be tempted to hold only stocks and abandon bonds. But I think that would be a mistake. Just as it makes sense to hold a broadly diversified group of stocks for the long run, preferably through low-cost index funds, there is value in bonds, too.
Rejoice, yes, but then worry.
First, this is no time to be complacent about stocks, not with inflation surging, millions of people still out of work and the coronavirus still at large in the United States and ravaging millions around the world. Even if you wear blinders and focus solely on the markets and the companies that underlie it, there are problems aplenty.
For one thing, some Wall Street strategists, normally a bullish lot, are projecting that the stock market will fall about 2 percent in the remainder of this year, according to a Bloomberg survey. Some expect declines in 2022. In a report on Monday, Morgan Stanley said: “With financial conditions tightening and earnings growth slowing, the 12-month risk/reward for the broad indices looks unattractive at current prices.”
The surge in inflation — with the Consumer Price Index rising 6.2 percent in October from a year earlier, its fastest rate since 1990 — could disrupt the stock market. So could an abrupt response to inflation by the Federal Reserve.
The Fed has been cautious, announcing that it will begin tapering its bond purchases but promising to hold short-term interest rates low for a while. But it could be forced to act more rapidly if it deems inflation to have gotten out of control. Fed intervention set off the current bull market rally in March 2020, and it’s not hard to imagine that Fed intervention could end it.
Stock valuations are stretched.
The stock market keeps powering upward, and until that momentum shifts, it is hazardous to assume that the market will suddenly plummet. But its long rise has consequences: Most stocks are no longer bargains. As Robert Shiller, the Yale economist, has pointed out, an important measure of stock valuations, the cyclically adjusted price earnings (CAPE) ratio, has been hovering in a rarefied range, exceeded only in December 1999, during the dot-com bubble.
The Shiller index can’t predict short-term stock market movements, but, like other valuation measures, it suggests that stock market returns over the next decade are likely to be lower than those of the last one. Vanguard, for instance, projects that the U.S. stock market will produce annualized returns of only 2.4 to 4.4 percent for the next decade, in no small part because prices are so high.
Other world stock markets haven’t risen as much lately, and, partly for that reason, Vanguard expects that they will outpace the U.S. market by almost three percentage points, annualized, in the decade ahead. That’s a reminder that a truly diversified stock portfolio is a multinational one, containing shares from all major public stock markets (including those in China).
When stocks are terrifying.
The past is no guarantee of the future, but it provides clues. Countless academic studies suggest that the key to prosperity for nonprofessional investors is to hold stocks for the long term and avoid market timing.
That implies that investors need to be able to withstand big losses periodically because the stock market fluctuates, sometimes painfully, as it did last year. Recall that from Feb. 19 to March 23, 2020, the S&P 500 fell 34 percent. Further declines of that magnitude or greater could happen at any time.
Does that make you uneasy? It bothers me.
An excellent strategy for buffering losses and hanging on to stocks, come what may, has been to own bonds. That’s because bonds and stocks have been inversely correlated much of the time: When one rises, the other falls.
That beneficent relationship isn’t foolproof: The inverse correlation has broken down periodically, and the current low yields may limit bonds’ ability to counteract stock market losses. Still, several recent studies show that in periods of spiking inflation, bonds have performed their essential function: limiting portfolio losses and rising when stocks decline.
Bonds can be a balm.
I hold bonds because I’m afraid to hold only stocks. Yet I want to remain in the stock market because I don’t know exactly when it will rise.
Consider a study from Bank of America, “For Stocks, Time Really Is Money.” It found that from 1930 through March 8, 2021, the S&P 500 returned 17,715 percent cumulatively. But nearly all of those gains were concentrated in a relative handful of days, which occurred randomly. Exclude the 10 best days for each decade and nearly all the gains were erased, leaving the market with a return of only 28 percent over more than 90 years.
Basically, no one knows when the next big days in the market will come, but you won’t want to miss them. Still, I know my limits.
My mutual fund portfolio contains more than 40 percent bonds, which I view as insurance. When the stock market crashes, the bonds will be invaluable. I’ll sell some of them then at rich prices, and buy more stock cheaply, rebalancing the portfolio. You can do this yourself, or with professional help.
You can’t gain from stocks if you don’t hold them when they rise. But to stay calm and stick with the stock market, you may want to own bonds. Plenty of them.