Morningstar Advisor - October/November 2009 - 27

the additional amount of risk, it is not surprising that stocks don’t outperform bonds every period—even over extended periods of time. Stocks Versus Bonds, the Future Exhibit 1: Neck and Neck For 40 years, bonds have held their own against stocks. Period S&P 500 IA SBBI Inter-Term Government Bond BarCap/LB US Agg Bond IA SBBI Long-Term Government Bond How likely are stocks to outperform bonds going forward? To try to figure out the future, let us look in more detail at what happened during the past 40 years. Despite the substantial decline in yields over the past 40 years, the bulk of the bond returns come from the income return portion, or yield (Exhibit 4). On average, the bond income return from coupon payments was more than 7%. Capital gains caused by the yield decline made up the additional return. Today, yields are much lower (Exhibit 5). As of the end of the second quarter of 2009, the yield of the long-term government bond was 4.3%, and the intermediate-term government bond yield was only 2.51%. For bonds to continue to enjoy the same amount of capital gains over the next 40 years, a rough estimation would put the yield into negative territory, especially for intermediate-term government bonds. This is simply impossible, because it implies that investors would be willing to lend their money to a borrower and pay the borrower an interest rate. Over the past 40 years, bond investors have enjoyed abundant returns because of a high-yield environment followed by a steady decline in yields. To analyze which asset class is more likely to outperform going forward, let’s take a deeper look at the historical data and the current market environment. We analyze each component of returns going forward for stocks and bonds as follows: Bond returns current yield + capital gain Stock returns current yield + earning growth + P/E changes 1 year: Starting July 2008 5 year: Starting July 2004 10 year: Starting July 1999 20 year: Starting July 1989 30 year: Starting July 1979 40 year: Starting July 1969 Jan. 1926 – June 2009 –26.22 –2.24 –2.22 7.76 10.75 9.19 9.60 5.52 5.10 6.01 6.79 8.28 7.95 5.34 6.05 5.01 5.98 7.06 8.49 8.38* NA 7.67 7.14 7.55 8.55 9.46 8.53 5.47 Compound annualized total returns (%) ended June 2009. Source: Ibbotson. *BarCap/LB US Aggregate Bond Index only goes back to January 1976. Exhibit 2: No Contest Long Term Stocks have easily outpaced bonds over the past 83 years. 10,000 Compound annual return Small stocks Large stocks Government bonds Treasury bills Inflation 11.7% 9.6% 5.7% 3.7% 3.0% $9,549 $2,049 1,000 $99 $21 $12 $1 0.10 1926 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: Ibbotson SBBI Chart: Stocks, Bonds, Bills, and Inflation 1926–2008. Exhibit 3: Since 1825 For nearly two centuries, stocks have performed well. Period Large Company Stocks January 1825 – December 1925 January 1926 – June 2009 January 1825 – June 2009 7.3 9.6 8.3 Compound annualized total returns (%). Stock returns from 1825-1925 are from the article written by William N. Goetzmann, Roger Ibbotson, and Liang Peng, “A New Historical Database for the NYSE 1815 to 1925: Performance and Predictability,” Journal of Financial Markets, Dec. 2000. MorningstarAdvisor.com 27
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Morningstar Advisor - October/November 2009

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