Marilyn Monroe was a physically beautiful woman who figured out early in her career that coloring her hair blonde would draw attention.  Not only did it further her career, but it led her to make a movie called “Gentlemen Prefer Blondes”.  We at Smead Capital Management are sure that women, who are intelligent and beautiful without being blonde, are dumbfounded by the attraction men have to platinum hair.  It doesn’t surprise us, however, because we have been seeing the same kind of visual and emotional attraction work in the investment markets over the last 29 years.  As we look out into the fourth quarter of 2009, we will look at one of those eye-catchers today because “Gentlemen Prefer Bonds”.

In 1984, Treasury Bonds that matured in 5, 10 and 30 years were yielding approximately 13.5% despite a trailing 12-month inflation rate of 4%. Investors had done so poorly over the prior 30 years in their bond investments that they wanted little to do with some of the best rates of return that anyone had ever seen from the least risky credit issuer in the world.  Treasury interest rates had started at 2 to 3% in the early 1950’s and had risen inexorably during that 30-year period and folks had spent that time seeing their bonds depreciate.  In SCM terms, bonds going down in price became a “Well Known Fact”. Everyone knew that bond prices went down over the prior twenty years and everyone had acted on their belief.

A young economist/stockbroker at the time, I didn’t yet have a discipline to buy and hold quality common stocks.  I did have the common sense to believe experienced investment managers like Jack McCarthy (Lord Abbett), who told us that those returns should be locked in and were likely to be looked back on as an anomaly and an investment blessing.  Most investors preferred short-term Certificates of Deposit and money-market fund investments which had similar rates, but weren’t guaranteed for longer than a few years.  The fear of inflation had attracted investment dollars to a different kind of glamour in the late 1970’s and early 1980’s (Gold) and guaranteed double-digit returns didn’t have a very sexy history.

We have now reversed the interest rates and the circumstance.  The 5, 10 and 30-year Treasury Bonds pay 2.33%, 3.42% and 4.27%, respectively.  As interest rates have fallen, investors have basked in years of cash flow and rising bond prices.  The most popular money manager of today and the most respected in many ways is Bill Gross.  He runs the largest bond fund, PIMCO Total Return, and his company dominates bond investing.  They run such large amounts of money that they move the markets all by themselves, much like Warren Buffett’s new stock purchases moved investors in the 1980’s and 1990’s.  His monthly letter is anticipated and widely disseminated when it hits the internet at the beginning of each month.  Bill Gross and Pimco are to bonds what Marilyn Monroe was to movie goers in the 1950’s and early 1960’s.

What made me think of all this was an article at the website Marketwatch called “Irrational Exuberance in the Bond Market?”  It was written by Mark Hulbert, a long time follower of investment advisors and newsletter writers.  He pointed out that investors had put net inflows of $214 billion into bond mutual funds since the beginning of March and just $10.5 billion into equity mutual funds as of September 18 of 2009.  This is despite the fact the stock market has had one of its best six-month runs in over 60 years! These mutual fund flow statistics show that investors have been trained by market forces over the last ten years to prefer bonds over stocks and have produced a very confident set of analysts who are trying to explain that stocks never really had a long-term statistical advantage over bonds.  They now argue vociferously those investors, especially retired investors, should under-weight common stocks and over-weight bonds.  The executives at PIMCO must be grinning from ear to ear, just like Twentieth Century Fox execs were when the box office receipts were counted back in 1953-54 on Marilyn’s blockbuster movie.

The analysts who are recommending bonds over stocks are missing a very big problem.  What you are going to make on a bond held to maturity is fixed.  Therefore, you unequivocally can’t make better than 3.42% if you buy a ten-year Treasury bond today and hold it to maturity.  How can someone in good conscience scare folks with ten-year or greater life expectancy out of good quality stocks at reasonable prices. It baffles us at SCM and makes the Treasury bond investments look like an expensive date.  With average dividends above 2% and possible dividend growth to come, stocks would only have to appreciate 1.5% per year on average to beat the ten-year bond return.  Ibbotson shows that stocks, as represented by the S&P 500 Index, have appreciated around 5.33%, historically on a pure stock price appreciation basis.

This takes us to the research done by Jim O’Shaughnessy’s firm back in March of 2009 called a “Generational Opportunity”.  Looking backward over prior 40-year stretches since 1940, O’Shaughnessy found that there were only 3 times that you could look backward and find a real (inflation adjusted) return under 4% out of 545 look back periods in common stocks.  On the other hand, there was only ONE look back out of 545 on Treasury Bonds which earned a better real return than stocks did in their worst THREE 40-year views.  Therefore, if history is any guide, it is an unbelievably low possibility that a diversified common stock investor wouldn’t beat the after tax return on the 10 or 30-year Treasury bond at the current rates over the next 10 and 30 years of investing. 

       
Source:  A Generational Opportunity, Market Commentary by Jim O’Shaughnessy, March 16, 2009

Gentlemen prefer bonds at the time that Treasury bonds are statistically the least likely to reward investors for long stretches as at any point since 1950.  And they are ignoring the beautiful woman sitting beside the bonds; her name is “Common Stocks”.  We wonder how popular bond managers will be if bonds depreciate over the next twenty years and bond yields gravitate to the mean.  We believe that recession-resistant large cap stocks with strong balance sheets and brands could be a “Twenty-First Century Fox”.