Getting Real
Monday morning. Our investment team gathers around our cozy conference table for our weekly meeting. The first topic of discussion, without fail: Stocks or bonds.
It’s a classic debate, and rightly so. Bonds are attractive, and they feel comfortable. Given their limited correlation with the topsy-turvy equity markets, they can look downright seductive. After all, who wouldn’t want a safe harbor to shelter their capital?
But, running our portfolio on what “feels” most comfortable isn’t what our clients hire us to do. Our mission at Twin Gryphon centers around knowing when to take a risk and when to stand down. When we put our feelings aside and dive into some careful analysis, we can get closer to those correct decisions.
Let’s take a look…
Stocks or Bonds: What We See
If we start with just fixed income strategies, bonds certainly have their advantages in today’s market. Interest rates are falling, and bond values rise as a consequence. Just recently we’ve seen the 10-year treasury yield drop from 3% late last year to where it currently sits at 2%. And, just in case you’re thinking us “anti-bond,” think again — these market conditions led us to take some ETF bond positions that have proved quite lucrative in the short term.
But, our fortunes aren’t made in the short term, at least not in our world. Assets are grown slowly, and we need to take time itself into account. We must keep an eye on the “real rates of return.”
Sure, the safety of a ten-year treasury bond might have you sleeping easy at night, but perhaps it shouldn’t. The “real rate of return” is the “total yield (nominal yield)” minus the inflation rate. (Classic inflation — sneaking up on us when we least expect it.)
Below is a table comparing the 10-year treasury yield vs the inflation rate, (we used https://ycharts.com/indicators/us_inflation_rate for this table and the yield chart that follows)
Year 10 Year Treasury Rate Inflation Rate
2006 4.42% 2.50%
2007 4.76% 4.10%
2008 3.74% 0.10%
2009 2.52% 2.70%
2010 3.73% 1.50%
2011 3.39% 3.00%
2012 1.97% 1.70%
2013 1.91% 1.50%
2014 2.86% 0.80%
2015 1.88% 0.70%
2016 2.09% 2.10%
2017 2.43% 2.10%
2018 2.58% 1.90%
2019 2.00% 1.80%
Take a look at 2016 through 2019. Yikes. The yield, once you consider inflation, runs from a dismal -0.01% in 2016 to a meager 0.20% in 2019. Plus, if we take tax rates into account, a 30% rate puts the after-tax yields in the negative for 2016-2019.
So, is your bond investment safe? Yes. Is it losing money over time? Also yes.
Let’s shake those depressing numbers off and look at some stocks instead. We hear you — stocks can feel like a tornado of trade wars, tax issues, and constant Tweets all headed towards a cliff. But take a look at the S&P 500:
Currently, the P/E is about 19 trailing (source: https://ycharts.com/indicators/sp_500_pe_ratio), giving us an earnings yield of 5.3% That’s 4-5% higher than those treasury returns we just looked at. Not too shabby.
Of course, there are plenty of S&P 500 stocks not doing so hot right now (just look at energy.) So let’s focus on a stock growing at a hearty 8% annually. We don’t need to dig up a hotshot tech stock to do this; our friendly neighborhood Darden Restaurants (Olive Garden, Longhorn Steakhouse, among others) has grown its earnings 20% per year since 2016 (source: Darden Financials). To keep things reasonable, though, we’ll use that 8% as a conservative estimate.
Yep, I know what you’re thinking: stocks can vary wildly. How do we know that 8% will still be 8% tomorrow? In the short-term, we don’t, and that fluctuating behavior can be frightening. But, we can get more comfortable making assumptions over time and safely project that stock returns will simply mirror earnings growth.
Take a look here at the difference in projected account values over the long term:
Conclusion
We hear from many of our clients about their apprehensions surrounding the stock market. Believe me, these worries don’t fall on deaf ears. The truth is, we’d be lying if we said it didn’t scare us a bit too — even when it’s going up!
But, we can’t let this natural fear override our analysis. Finding longer-term opportunities on behalf of our clients is central to our focus. After all, that’s what we’re here for.
With much appreciation,
Tim