There is a confluence of factors that are painting a very odd picture of current investor behavior and US money reserve. Common sense and a careful analysis of the market dynamics between equities and bonds today would indicate that investors should be acting in the exact opposite manner than they are. Interest rates are hovering at a 100-year low, which creates two problems for investors. First, there is not enough return from bonds to fund a retiree’s income needs or to fight inflation. Second, investing in bonds with interest rates so low makes it riskier to own bonds today than it has been in over a century.
Conversely, many US equities, especially blue-chip dividend paying equities with long histories of paying and increasing their dividends are at historically low valuations, and therefore, offering historically above-average current yields. Furthermore, high-quality blue-chip US corporations are perhaps in better financial health than we’ve seen in decades. Consequently, low valuation and healthy corporate financials would indicate that quality equities offer lower real levels of risk and higher long-term returns than they have in decades.
Nevertheless, investors are not only making a classic mistake, I believe they are making a very obvious and thus quite avoidable mistake. It is an undeniable fact that bond prices go down when interest rates go up. Since interest rates cannot go to zero or below, it logically follows that interest rates have nowhere to go over the long term but up. Perhaps, as many believe, federal intervention may keep rates low for another year or so. But in the longer run, the powerful forces of the market can only be contained for so long.
Yet given what I’ve already said, we continue to see that bond mutual fund inflows remain at a record high, while simultaneously equity fund outflows are some of the largest on record. In other words, investors are selling stocks, the undervalued out-of-favor asset class and investing into the most overvalued asset class – U.S. Treasury bonds. I believe that people are forgetting that bond prices can fluctuate just like stocks. And with interest rates at such an extreme low level, bond price fluctuations could be more severe than equities have been even during their worst days.
The Evident Risk Profile of Bonds
In searching the Internet for a long-term graphic on 10-year U.S. Treasury notes I came across the following 110-year chart courtesy of the financial blog Observations. Although the chart from 1950 through 2010 illustrates a clear mirror image of interest-rate behavior, the portion going back to 1900 is even more illuminating. This is not statistical mumbo-jumbo showing correlation without causation, this is a factual depiction of interest rates spanning over 110 years. This casts a bright light on the risk of bonds to anyone that understands the interest rate and bond price relationship. Rates clearly have nowhere to go but up long term, and when they do, prices of existing bonds will collapse. To be clear, I didn’t say drop, I said collapse. Bond buyers beware.
To summarize, the only rational reason that people are eschewing stocks in favor of bonds is fear. The precipitous drop in stock prices during the great recession has yet to be forgotten. On the other hand, what is forgotten is the fact that the same thing can happen to bonds as well. Therefore, I believe the irrationally exuberant confidence in bonds is ill-gotten. The only reason bond prices haven’t fallen in 30 years is because interest rates have been falling since the early 1980s. When interest rates fall, bond prices go up and therefore an even greater aura of safety surrounds bonds. Keep in mind; although prices on pre-issued bonds will go to a premium as interest rates are falling, the premium vanishes at maturity.
Furthermore, at maturity, investors are forced to reinvest in new bonds at lower rates than they had on the existing bonds that matured. Regardless, stability with bond values makes people feel good. This was not true from 1950 to the early 1980s. When interest rates are rising, holders of existing bonds will see their principal devastated. Consequently, they will have less capital available to invest in the new and higher interest rates when they occur. As a result, even though rates go higher, investors will fail to take advantage of it because they will have less money to invest.
The Case for Blue-chip Dividend Paying Stocks
One of the biggest misconceptions that I believe people erroneously hold regarding equities is the notion that all equities are the same. In truth, equities come in many different flavors, some good and some not so good, therefore, to paint all equities with the same brush stroke is both misleading and unfair. This is why I so vehemently argue against evaluating and even making investment decisions based on generalities like “the stock market is high or the stock market is low.” Instead, I believe in evaluating each specific holding that I might consider thus making my decisions on a case-by-case and I feel more rational basis.
Additionally, there are several facts regarding the long-term ownership of quality dividend paying equities that many people either overlook or forget. But perhaps the most important fact is that any of the damage that the great recession caused was only temporary in nature for the prudent and intelligently patient investor. The prudent investor is defined as one who in the first place, was careful to only invest in blue-chip equities when valuations made sense. This is especially true for the best-of-breed blue chips that continued to generate strong earnings during the recession and consequently raised their dividends. Inevitably, the stock prices on quality companies whose earnings held up eventually return to fair value.
It’s true that generally speaking, their stock prices did drop along with most other stocks, but because their businesses remained strong and healthy their stock prices did recover, and as I already stated, the income that they generated never faltered. In other words, as long as the stocks were not panic sold out into price weakness, existing shareholders soon recovered their temporary losses while continuing to enjoy a steadily growing dividend income stream along the way. As I also stated before, it’s not the volatility itself that represents risk, but rather the emotional reaction to volatility which is where the real risk sits.
Two classic examples of what I’m describing thus far can be found by examining the businesses behind McDonald’s Corp. (MCD) and Kimberly-Clark Corp (KMB) in conjunction with how the marketplace treated their stock prices during the great recession. I will utilize the F.A.S.T. Graphs™ (fundamentals analyzer software tool) to vividly illustrate my points. To focus the reader, my points are that even a catastrophic event such as the great recession of 2008, did not have a permanent long-term effect on best-of-breed companies that were able to maintain their businesses in spite of the economic challenges.
McDonald’s Corp. During the Recessionary Years
My first example, McDonald’s Corp., represents a Dividend Champion and Dividend Aristocrat blue-chip with a consistent, above average and clearly recession-resistant track