Time to give up on shares?

Bonds have beaten shares over the last 30 years for the first time since 1861. Is it time to give up on shares and stick to bonds and term deposits? Although it's tempting, you could be making a big mistake.

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Stocks for the long term, eh? How long a term? Ten years? Well, that hasn't been so good. How about thirty years? Sorry, dear reader, but that hasn't worked lately, either.

The blaring Bloomberg headline from the U.S. recently read, "Bonds Beat Stocks Over 30 Years for First Time Since 1861."

Ouch. Is that check and mate for the "long term" stock investors?

How did this happen?
Quite simply, 1981 was a great time to be an investor. It might not have seemed like it at the time – interest rates were through the roof, inflation was screaming, there was general economic uncertainty but in retrospect, this is when you wanted to be pouring money into the market.

Interest rates may have crimped consumers at the time, but long-term bond yields were sky high, which also means that prices were low. At the same time, all of the skittishness caused investors to push valuations down in the stock market as well.

In short, if you were a buyer in 1981, kudos to you because you've done quite well whether you were buying stocks or bonds.

With both bond and stock yields (stock yield being earnings divided by price) crazy high back then, prices were low and poised to start rising.

Ever since, we've seen a long stretch of rising prices for both stocks and bonds, while the yields for both have been in a race for the bottom. It's a race that bonds have been winning lately. This chart, comparing US bond yields with the returns from the US S&P 500 stock index illustrates the point.

Sources: Irrationalexuberance.com and author's calculations. S&P 500 earnings yield = inverse of 10-year price-to-earnings ratio.

What happens next?
I'd love to say that something great is in store for investors, but it's tough to be quite that optimistic. With yields beaten down to a pulp, investors can either invest to collect those unattractive yields or they can get fed up, pull their money out, and let prices fall until yields are back at attractive levels.

That is, of course, oversimplifying the story, but we saw basically that scenario during the 30 years leading up to 1981.

Sources: Irrationalexuberance.com and author's calculations. S&P 500 earnings yield = inverse of 10-year price-to-earnings ratio.

Taking this all into consideration, I couldn't give a hoot who beat what over the past 30 years. What really concerns me is with prices high (and yields low) for both stocks and bonds right now, how the heck am I going to score decent returns over the next 30 years?

Sticking with stocks
Over the next 30 years I'm far more positive about stocks than I am about bonds. This is for two primary reasons.

  1. Current yield. Whether you're looking at a one-year earnings yield, a 10-year, or something in between, the yield on stocks is a heck of a lot more than what you can get from bonds right now.
  2. Earnings growth. If you invest $1,000 in a vanilla 10-year bond today with a 2% yield, you'll get $20 per year for your investment over the next year. The year after that? $20. Five years from now? $20. However, if you invest that same $1,000 in a stock, there is the possibility that the earnings attributable to your shares will grow.

Combine those two points and I find it extremely hard to get excited about bonds at all.

In the U.S., the overall S&P 500 earnings yield based on 10-year average earnings is 5.2%. Like any index, that's just an average. The good thing about averages is that, by definition, half of the index is above that level while the other half is below (true – depending on how the index is weighted, the number of stocks may be different, but the concept holds).

A sweep through some of the ASX 50 companies presents many household names that soundly beat that average.  Again, the earnings yield is the inverse of the price earnings ratio and companies such as ANZ (ASX: ANZ), BHP Billiton (ASX: BHP), Fortescue Metals (ASX: FMG) and Westfield Retail Trust (ASX: WRT) are in double figures; well in excess of the S&P 500 average. In fact, the numerical average of the ASX 50 itself is over 7%.

Foolish take-away
Sure, Australian term deposits are offering a very handy interest rate right now, but my point above still holds – the starting yield might be attractive, but growth is guaranteed to be zero. And none of the above includes the additional franking credits for those companies paying dividends.

Bonds may have beaten U.S. stocks over the last 30 years, but at current prices, my money is on stocks.

Are you looking for quality stock ideas? Motley Fool readers can click here to request a new free report titled The Motley Fool's Top Stock For 2012.

Matt Koppenheffer is a The Motley Fool feature columnist. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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