Broad View

September 3, 2009

If we define the five broad asset classes as follows:

 1) Stocks

 2) Bonds

 3) Cash (Money market funds, T-bills, Shorter-term CDs, etc.)

 4) Real Estate

 5) Hard Assets (Commodities, Antiques, collectibles, Art, etc.)

Stocks should be the best performers over the next decade. This prediction has less to do with our overall outlook on the economy, market, and valuations, and more to do with where investors are putting their money. Investors often shift money to broad categories and specific areas after a hot streak and shortly  before a period of underperformance starts.

Frankly, hard assets shouldn’t even be on this list, since we define long-term investments as those capable of producing a stream of cash flows, either in the present (bonds and profitable stocks), or future (growth stocks with no current profits). 

Investors still like commodities in spite of the drubbing they took last year, and have been more than happy to jump back in as prices rebounded this year, apparently hoping to position themselves for the next big move into triple-digit oil.

Real estate is superior to hard assets, but will continue to have limited appeal until more money comes out of the asset class.

Even in the face of massive price drops not seen in the US since the 1920's and 30's, and with deflation and a Florida real estate bubble pop destroying home values, real estate still appeals to most investors. The main obstacle preventing a resurgence of excessive real estate investing is a lack of financing. Apparently, banks have realized the downside to real estate, even if borrowers still want in on the action.

Real estate, unlike hard assets, offers income potential, and provides a far better hedge against inflation, especially since it is often purchased with fixed rate loan dollars. There will come a time when real estate may outperform stocks, but real estate prices will have to sink a bit more (or stocks grow more expensive) before that happens. 

Cash is still a very popular asset class, but it’s growing less popular by the day. Money has been flowing out of money market funds for the past six months, capped off by a roughly $50 billion dollar outflow in July. Looking at past fund flows, it appears money markets reached peak attractiveness to investors at precisely the worst time to shift assets to cash from just about anything else: March 2009. 

You can’t blame investors for bailing on cash lately. In addition to the exciting upward move in stocks, the Fed has effectively set interest rates at zero, which is now reflected in low money market yields. This move was part of the effort to stimulate the economy and encourage investors to move back into riskier assets desperately in need of their emotional and financial support. Fortunately for safety seekers, prices in general are falling, so a dollar in 2010 may buy more than a dollar in 2009 does. The real inflation-adjusted return of money market funds is perhaps 2-3% - tax-free. That's better than earning 5% on a money market fund when inflation is 3%, since your after-tax return is zero, adjusting for inflation and taxes. 

Bonds are fast becoming the place to be, due mainly to a move back into riskier corporate bonds (kicked off because now that it appears soup lines are not in our immediate future — hopefully this time, everybody won’t be wrong, as is unfortunately often the case). This trend is a bit dangerous, since today's bonds have limited upside, yet in a doomsday economic scenario could still fall victim to a big hit – as much as 50% of stock market downside (for non-government debt), with only a fraction of the upside.

Since early 2007, investors have added nearly a  third of a trillion dollars to bond funds. That pace picked up this year, despite low interest rates on bonds. Lately, we’ve seen about $30 billion flooding into bond funds each month.

The only way a bond investment is going to beat stocks and even real estate over the next decades is with low inflation rates, low interest rates, and slow economic growth. Although this is possible, it is the best-case scenario – enough strength in the economy to keep default at bay and the bond payments coming, yet not enough for stock earnings growth to outpace bond yields, nor enough to lead to higher interest rates, which could hurt those in current lower-yield, longer-term bonds. Japan in the 1990's comes to mind.

Stocks have been bringing in respectable money now that "the bottom is in" theory has gained widespread acceptance. Broadly speaking, investors began avoiding US stocks in March of 2007, and by the summer of 2008, eventually gave up on even formerly popular foreign stock funds. 

Although the money has been coming back, domestic stock funds have seen withdrawals of nearly $200 billion since early 2007. During the same time period, about $50 billion went into foreign stock funds. Since the March low (when fund investors were bailing on all stock funds, big-time,) domestic stock funds have brought in more money, but after hot recent rebounds abroad, fund investors are now leaning toward foreign funds once again.

With this backdrop of investor behavior - which tends to be wrong - we expect US stocks to be the top banana over the next decade. How good this return is in absolute terms depends upon impossible-to-predict long-term economic and earnings growth rates. Stock performance could be as bleak as 3% a year, which would still be better than losing 2% a year in real estate or even more in commodities. At this point, the value of cash and bonds in portfolios is safety – so you don’t lose 50% of your money at a time you may need it – and to give you something to shift into stocks on future weakness that would increase expected stock returns.  

The move into bonds by investors may not wind down anytime soon, and we could see even stranger valuation comparisons — for example, a 3% average fixed yield on the total bond market, while the S&P 500 yields 3%, a yield that generally grows over time as dividends increase.

Today, the total bond market yields just under 4%. Normally, that figure alone would make for a bad comparison to stocks. But now that corporate America has taken the axe to dividends, yields are down to about 2.3% on the S&P 500, even after the big drop in stock prices.