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In Goodbye TINA, Hello BAAA, I made the case that investors should expect better total returns from bonds than stocks over the next 10 years. To be clear, investors should not ditch stocks and hold only bonds. But if I am correct and bonds generally outperform stocks, picking the right stocks instead of the most popular ones may be more rewarding than investors have grown accustomed.
The overwhelming popularity of passive investment strategies has dramatically diminished the value of stock picking. Instead of actively picking stocks offering the most value, unique fundamental traits, or the right industry, passive investors have been rewarded for picking the top dozen or so stocks in the most popular equity ETFs. As we enter a period of potentially low expected stock returns, passive investing may be less appealing, and once again, the art of stock picking may be of value.
In this article, I look back to other periods when bonds outperformed stocks. This analysis allows us to assess specific stock traits and specific industries that over- and underperformed in prior bonds are an alternative (BAAA) eras.
The BAAA era is coming
The graph below shows the cyclicality of monthly 10-year excess total returns for stocks versus bonds.
My methodology to calculate total returns assumed that we buy and hold the S&P 500 for 10 years and a 10-year UST bond until maturity. As such, there are no price gains or losses on the bond.
The recurring 10-year periods when bonds outperformed stocks are highlighted in red. The date and excess return figures on the graph are for the 10-year periods ending on that date. For example, the excess return figure for June 1974 is based on the period from June 1964 to June 1974.
I do not have access to the equity data required to evaluate which types of stocks outperformed in the first red instance covering the later 1930s and early 1940s. As such, I only performed my analysis on the three 10-year periods ending in 1975, 1980, and 2012.
The data and industry classifications are courtesy of Kenneth R. French. His database provides monthly stock returns broken down into deciles for many variables.
French may be best known for his work with Eugene Fama in which they debunked the capital asset pricing model (CAPM). Fama and French rightly claimed that beta, or the market, isn’t the sole factor explaining stock returns. Their theory promotes active, not passive investing strategies.
Stock factors
My first set of analyses focuses on stock factors. Factors classify stocks by certain traits. Examples include size, dividend, and earnings quality. My analysis looked at returns for the top and bottom 20% of stocks per factor category. I considered the following factors: value/growth, dividends, size, beta, and operating margins.
The excess returns were relatively consistent across the three time periods despite a long gap between the most recent and prior periods. The figures represent the excess annualized total returns of the top 20% of holdings for each factor versus the bottom 20%. For instance, the top 20% of stocks sorted by price to earnings (value) beat the 20% most expensive stocks by 6.73% annually on average over the three periods.
Investors choosing large-cap and value stocks versus smaller cap and growth stocks picked up 6-7% annually over the three periods. Higher dividend stocks outperformed lower dividend stocks by almost 3% annually on average. Since bond yields were attractive in the three periods, investors could earn a respectable income from bonds and were likely not as focused on stock dividends as they usually might be.
Lower beta stocks did better than higher beta stocks. Lower beta stocks tend to be more value-oriented, so the results are expected.
Stocks with lower operating margins did better than those with higher profitability. This was also likely due to their value orientation.
Industries
Next, I scanned 11 industries to see which ones out and underperformed over the three periods. The industry classifications and data are also from French. The average for the three periods is labeled.
Energy was the best-performing industry during periods when bonds provide better returns than stocks. Durables, while up on average 5.82% annually, were the worst performing.
The distinction seems to make sense as the higher inflationary environments are better for those mining or drilling and selling commodities versus those who must buy raw goods to assemble them.
Summary
Expected stock returns are on par with risk-free Treasury yields but woefully below the premium spread investors should demand. The simple conclusion is that for the entirety of the next ten years, bonds are the better bet. – Goodbye TINA, Hello BAAA
Since 1950, stock investors have earned an additional 5.53% versus bonds. In Goodbye TINA, Hello BAAA, I considered bonds the better bet because a 4% yield on a Treasury bond is on par with expected equity returns. Consider the 5.53% premium investors should demand on top of the 4% and the case for bonds versus equities is a “piece of cake.”
Equities, even in a bond-friendly environment, are an essential part of a portfolio for diversification and risk management. While you may not hold as many stocks as a percentage in a bond-friendly climate, you may be well rewarded for pricking the right ones. Hopefully, this helps you consider what might be “right” in the coming years.
Michael Lebowitz has been involved in trading, portfolio construction, and risk management involving some of the largest and most active portfolios in the world. In addition to broad institutional experience, he also built a successful independent RIA allowing him to further extend his experience into the realm of investment management for individuals and family offices. Grounded in logic and common sense, he blends vast trading and investment expertise with economic viewpoints that delivers pragmatic and actionable thought leadership to clients.
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Read more articles by Michael Lebowitz
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
I do not have access to the equity data required to evaluate which types of stocks outperformed in the first red instance covering the later 1930s and early 1940s. As such, I only performed my analysis on the three 10-year periods ending in 1975, 1980, and 2012.
Investors choosing large-cap and value stocks versus smaller cap and growth stocks picked up 6-7% annually over the three periods. Higher dividend stocks outperformed lower dividend stocks by almost 3% annually on average. Since bond yields were attractive in the three periods, investors could earn a respectable income from bonds and were likely not as focused on stock dividends as they usually might be.
