A key conundrum for investors is as follows: On the one hand, the data on tactical trading is clear. It tells us that making frequent changes to a portfolio is a bad idea and can damage returns. But on the other hand, we shouldn’t be so wedded to the status quo that we’re unwilling to ever make a change. With this conundrum in mind, it was notable when investor and author Howard Marks declared a “sea change” in the investment landscape and recommended that investors make sweeping changes to their portfolios.
The sea change Marks is referring to is the reversal in interest rates that we’ve experienced over the past 18 months. In round numbers, interest rates in the U.S. declined by about 20 percentage points between 1980 and 2020. But after bottoming near zero, rates moved up rapidly, such that the Federal Reserve’s benchmark rate is now north of 5%.
To see why this change in the direction of interest rates is so important, let’s start with some background. Higher rates have been a boon to savers, making it easy, for the first time in a long time, to earn a meaningful rate of return on cash and bonds. But higher rates have negatively impacted stock prices, for a few reasons. First, higher rates make it more expensive for companies to borrow. This reduces their profits, and all things being equal, translates to lower share prices. In addition, when bond returns become relatively more attractive, some investors will shift their investment dollars from stocks to bonds. At the margin, this dynamic puts downward pressure on stock prices, since stocks are affected by supply and demand. And finally, because a company’s value should, in theory, reflect the present value of its future profits, higher rates translate to lower stock prices.
While stock prices have recovered some of last year’s losses, Marks isn’t so sanguine about their future, and this is where he believes a sea change is underway. Stocks, Marks argues, will see more muted returns in the coming years because they won’t enjoy the tailwind of declining rates that had boosted returns for 40 years. Falling rates, he says, were “probably responsible for the lion’s share of investment profits made over that period.” But going forward, Marks sees stocks facing the three headwinds described above. Bonds, on the other hand, now look comparatively more attractive. Marks points specifically to high-yield bonds, which today are paying closer to 8%—not far off from stocks’ long-term average of 10%. For these reasons, Marks says investors should shift “a substantial portion of portfolios…perhaps the majority” over to bonds.
Usually, I agree with Marks’s recommendations, but in this case I see things differently and wouldn’t recommend making a big shift into bonds. Why? In his memo, Marks acknowledges several ways in which this sea change forecast might be wrong. Chief among them is this point: Bonds, by their nature, “don’t have much potential for appreciation.” Unless it’s in the deep-value end of fixed income—an area which isn’t readily accessible to individual investors—it’s hard to realize big gains with bonds. In contrast, stocks have theoretically unlimited potential for appreciation.
To better understand this difference, consider Apple. The company has more than $150 billion in bonds outstanding. But what would happen if Apple developed a profitable new product? Its bonds wouldn’t gain even a sliver of value. Apple’s stockholders, on the other hand, would benefit greatly if a new product boosted revenue and profits. While Apple is a special case, this dynamic is universal and illustrates the fundamental difference between stocks and bonds. Stocks allow investors to participate in the upside of companies’ innovation, while bonds returns are essentially capped.
Despite the structural advantage of stocks, could Marks’s forecast still be correct? If 40 years of declining rates artificially boosted stock market returns, then will future returns necessarily be more muted? On the surface, the numbers do support Marks’s argument. Between 1926 and 1979, the U.S. stock market’s average annual return was 9.0%. But between 1980, the year when interest rates began to drop, and the end of last year, returns averaged a much loftier 11.5%. These higher returns do seem to support Marks’s argument, but where I would disagree is in the interpretation. While it would be nice to continue to enjoy the higher returns we’ve seen since 1980, that doesn’t mean the alternative is so dismal. If stock market returns reverted to their pre-1980 level of 9%, that would still beat the returns available on bonds today. And that, in my view, is the comparison that’s most important.
Dimensional Fund Advisors offers another lens through which to compare stocks and bonds. Between 1926 and 2022, a dollar invested in the S&P 500 would have grown to $11,527. That same dollar, however, invested in bonds would have turned into just $22 (for short-term bonds) or $131 (for long-term). The comparison isn’t even close. The upshot: While bonds might be relatively more attractive today than they were in the past, the data suggests that bonds will remain relatively less attractive compared to stocks.
Jeremy Siegel, writing in Stocks for the Long Run, provides an even longer-term perspective. Between 1802 and 2012, stocks delivered real returns—that is, on top of inflation—of 6.6% per year. Bonds, on the other hand, returned just 3.6% per year. To be sure, there have been periods when bonds have outperformed stocks, but over the long term, that has not been the case.
A final fly in the ointment for bonds: In highlighting the attractive prospects of bonds, Marks is mainly referring to the 8% yields available today on high-yield bonds. The trouble, however, is that high-yield bonds, in my opinion, aren’t ideal for individual investors. That’s because, unlike Treasury bonds, high-yield bonds are highly correlated with stocks—with a correlation around 0.9 on a scale from -1 to 1. Thus, when stocks drop, high-yield bonds tend to drop as well.
Consider the first three months of 2020. When Covid emerged, stocks dropped by about 21%, but Treasury bonds and other investment-grade bonds gained 2% or 3%. This is precisely what an investor would have wanted, and why a stock-bond portfolio is, in my opinion, an ideal combination. But not all bonds are the same. Because high-yield bonds are positively correlated with stocks, they dropped in value—by more than 10%—in those early months of 2020. In other words, they did the opposite of what an investor would have wanted. (You can see a comparative chart here.)
As the old adage goes, there is no free lunch. High-yield bonds do offer attractive returns today, but history suggests they’ll do little to protect a portfolio when the stock market drops. Treasurys and other investment-grade bonds, on the other hand, have low or even negative correlations with stocks and should thus provide good portfolio protection during stock market downturns. But in exchange for that increased stability, their returns pale in comparison to stocks.
Is it possible that stock returns will be lower over the next 40 years than over the past 40? Yes. But does that mean bonds are now the better place for the majority of your savings? I would be wary of that conclusion.