Why Stocks And Bonds Are Useless

Looking forward, traditional investments are unlikely to produce attractive returns over the next decade. The days of investing in an S&P 500 index fund and closing your eyes and hoping for the best are over.

Stocks are expensive, and interest rates on 10-year Treasuries are near historic lows as well.

Frankly, neither stocks nor bonds are likely to offer investors attractive risk‐adjusted nominal or real returns over the next few years. (My model portfolio recommends alternative investments, some of which we’ll discuss below.)

Here’s why traditional investments are doomed to underperform, and why you should severely limit your exposure to them before the Super Crash.

And here’s what you should buy instead….

The Stock Market Has Reached Saturation Point

The stock market has been on life support for some time now, and it can’t keep up the appearance of vitality for much longer. Investors who continue to rely on a rising market courtesy of the kindness (or errors) of central bankers are likely to be very disappointed in the years ahead.

The S&P 500 enjoyed an enviable run since hitting its post‐crisis low in March 2009, more than tripling in value by mid‐2015. This performance was due to a strong recovery in corporate earnings from 2009 recession lows, as well as massive liquidity flowing into the market courtesy of the trillions of dollars of new money created out of thin air by the Federal Reserve and other global central banks. Stock buybacks were one of the primary sources of this liquidity – but like any shot in the arm, they only worked for a while and were paid for with huge borrowings that now weigh down corporate balance sheets.

Unfortunately, the Fed’s policies failed to create sustainable economic growth and reached the point of diminishing returns from an economic and market standpoint by the end of 2014. It is arguable that the post-crisis bull market ended when the Fed terminated its QE program in October 2014 – the “stealth bear market” I’ve discussed elsewhere.

Two of the most highly respected strategists in the investment world, Rob Arnott at Performance Analytics and Jeremy Grantham at Grantham Mayo van Otterloo (GMO), forecast low returns for stocks over the next 7-10 years. In fact, adjusted for inflation, they are projecting negative returns.  As of December 31, 2015, GMO’s 7‐year real (i.e., inflation-adjusted) return forecasts was the following compared to the 6.5 percent long‐term historical return for U.S. equities:

U.S. Large Cap −1.8%
U.S. Small Cap 0.1%
U.S. High Quality 0.1%
International Large Cap 0.3%
International Small Cap −1.2%
Emerging Markets 4.0%

Performance Analytics had similar 10‐year real return projections as of mid-year 2015:

S&P 500 1.1%
Russell 2000 0.5%
MSCI EAFE (International) 5.3%
MSCI Emerging Markets 7.9%

Both firms forecast that only non‐U.S. equities are likely to generate meaningful returns over the next decade, and even those returns are relatively muted.  And their projections for emerging markets will only materialize if the U.S. dollar weakens – if the dollar remains strong, emerging markets will do very poorly.

Since 2008, investors reluctantly but steadily increased their investments in risk assets like stocks, junk bonds, MLPS, venture capital, and real estate that are theoretically capable of providing higher returns. Unfortunately, however, you can’t eat theory.  In fact, policies that drove interest rates down to zero effectively destroyed fixed income as a viable asset class and created a bubble in Internet, social media and biotech stocks while leaving the rest of the market overvalued.  So now investors face years of low returns on risk assets because the Federal Reserve cannot suppress interest rates forever.

This Market Is Even More Overvalued Than It Looks

One issue that receives less attention than it should but points to the market being even more overvalued than it looks is that the quality of earnings has deteriorated in recent years as companies employ various accounting tricks to inflate their earnings. This subject receives virtually no attention from Wall Street analysts or the financial media because they want to paint a rosy picture to fit their political and business interests.

For example, companies increase their reported earnings by so‐called “non‐GAAP” adjustments that include non-recurring or non‐cash charges that distort cash earnings. Overall, 2015 S&P 500 GAAP (actual) earnings were $787 billion compared to $1.04 trillion of “pro forma” (non-GAAP) earnings. S&P 500 GAAP earnings actually fell by 12.7% in 2015 according to S&P Dow Jones Indices. Naturally, S&P 500 companies reported “pro forma” year-over-year earnings growth of 0.4%. But the GAAP figure was the worst since the 2008 financial crisis.

In addition, earnings are inflated by the massive stock buybacks I mentioned above and by artificially low interest rates. On a cash basis, most corporations are earning far less than their reported earnings.

To sum it all up, the stock market is overvalued and unlikely to generate high returns for years to come.

The outlook isn’t much brighter for bonds, either.

The Fed Has Completely Destroyed Bonds As An Investment Class

Bonds have been turned into “certificates of confiscation” by the Federal Reserve. The question that now must be asked is whether the confiscation of capital from savers will be permanent.

One key concept investors need to understand is the difference between “nominal” and “real” returns. Governments thrive on their citizens’ failure to understand this difference. “Nominal” returns are measured in constant dollars unadjusted for inflation. “Real” returns are measured in inflation‐adjusted dollars.

The U.S. government continues to promote the fiction that the prices of goods and services are falling when real world prices (other than energy since mid- 2014) actually are rising at double‐digit rates.

 

For this reason, investors need to earn at least high single digit returns on their capital to keep up with rising prices and the debauchment of their dollars by central banks; lower returns leave them with very low or even negative real or inflation‐adjusted returns, meaning their dollars buy less of what they need to live every year. The reason there is so much political discussion about low wage growth is that American workers keep falling behind in terms of what their paychecks buy them in the real world. No less is true with respect to their investment returns although this important point receives far little media attention.

For evidence of this, we need look no further than the performance of the two largest bond funds in the world.

For the 3-year period ended March 14, 2016, the PIMCO Total Return Fund generated annualized returns of 1.28 percent, while for the 3-year period ended Feb. 29th, the Vanguard Total Bond Fund generated annualized returns of 1.97%. On a nominal basis those returns are unimpressive enough, but on an inflation‐adjusted basis they are effectively zero. Today, the PIMCO Total Return Fund has lost about 50% of its managed assets since its peak of $2.04 trillion in 2013. While many have attributed these outflows to the departure of Bill Gross as the fund’s manager, the real reason is consistently poor performance that started well before Mr. Gross’s exit.

While these large bond funds sell themselves based on relative performance (i.e., how they perform against their peers), investors should tire of being told that “in the kingdom of the blind, the one‐eyed man is king.” They can’t eat relative real returns of zero.  These returns stink and there is no reason for investors to pay to lose money, which is what they are doing when they invest in these funds.

While PIMCO’s and Vanguard’s returns reveal that these funds have been reduced to little more than glorified money market funds, they are actually much riskier than money market funds because they employ huge amounts of derivatives and leverage to earn these paltry returns. This means that their risk-adjusted returns are even worse than they appear and investors should be looking for alternatives. If these funds were half as adept at investing as they are at marketing, investors would have nothing to worry about. Then again, that could be said of most of the products sold by Wall Street.

The Future of Bond Returns Is Not Very Bright

Some highly regarded investors believe that interest rates will drop sharply over the next few years. Since they are already very low, interest rates would have to collapse to generate high returns. For example, it would require the yield on the 10-year Treasury to decline from 2% to 1% over 12 months to generate a total return of 12.8% (and 13.7% for 10-year zero coupon Treasuries). For the 30-year Treasury bond, a decline from 2.9% to 2.0% over a 12-month period would generate a 22.4% return (32.8% on 30-year zero coupon Treasuries). Such sharp declines in interest rates would almost certainly mean that the economy entered a recession (or worse) and that equities and other risk assets suffered severe, if not catastrophic, losses. Alternatively, only small jumps in interest rates would result in big losses for investors.

While I believe there is a reasonable likelihood that rates will move lower as the U.S. and global economy struggles in the years ahead, I believe the risk/reward with respect to high quality bonds (Treasuries, investment grade corporate, and municipal bonds) is poor. The most likely scenario is that bonds will continue to offer poor nominal and real (inflation adjusted) returns for a prolonged period of time in the best of circumstances and pose a serious risk of generating negative returns if central bank policies trigger higher inflation and higher interest rates. If central bankers have demonstrated anything, it is that they will double down on failed policies until they trigger a crisis. That crisis could manifest itself in higher inflation that will seriously hurt bond returns.

Alternative Investments

Here is the model portfolio I’ve recommended in my new book The Committee to Destroy the World:

  1. Gold, precious metals, tangible assets-10-20 percent
  2. Cash-10-20 percent
  3. Absolute return strategies-20-40 percent
  4. Dividend paying equities-20 percent
  5. Income generating securities-10-20 percent

You will notice that there is an allocation to “income generating securities” but not to bonds per se such as investment grade and municipal bonds and Treasuries. (Many absolute return strategies will also provide some bond exposure.) The types of investments that should be made to generate income directly are comprised of the following:

  1. Bank loans
  2. Closed-end mutual funds and mortgage REITs trading at a discount to NAV and paying high dividends
  3. Event-driven high yield bonds, bank loans, and convertible bonds.
  4. Bank preferred stocks

I’ll discuss these income-generating securities further in upcoming articles.

But beyond that, investors should minimize their bond exposure. Bonds have been destroyed by post-crisis central bank policies that have artificially suppressed interest rates around the world to zero (or less).

As for equities-by any reasonable measure, the overall stock market is extremely expensive today and the recent rally is most likely a bear market rally that will reverse before long.   For that reason, it is prudent to limit portfolios to only 20 percent equity exposure until valuations improve markedly.

Sincerely,

Michael

23 Responses to “Why Stocks And Bonds Are Useless”

  1. I agree with the article. Not sure about gold, since one buys at a premium then sells at a discount and legally the dealer must report all sales to the IRS. Although, foreign buyers may keep the price high. Not sure how independent investors can get in on bank loans. FED rate is 0.25% yet I notice a LOWES credit card for example is 24.5% percent. How can a retail investor benefit from that interest spread? Cash would be king only if the government permitted a nice honest market crash, but SEC will freeze trading until sell order pressure is exhausted. With preferred stock, why would there be any available now at a reasonable price? A preferred if it paid a high return, normally would sell now at a premium. However, if and when the FED rate returned to normal, then the preferred market price would drop in value and might stay that way for many years. So the retail investor might not lose the interest payment but never be able to recoup the initial investment. Banks do not have to issue high yield preferred with the existing 0.025 FED rates! Also, if purchased when the interest rate is this low, any significant increase in the FED rate would result in a drop in the value of a preferred share price. High yield bond, normally suggest high risk and poor fundamentals. How can a retail investor find high yield bonds of short duration with a firm that has a good credit rating? As I stated earlier, I agree with your analysis. It is just that for a typical retail investor with a retirement account, how does the retail investor with a retirement account implement these strategies? Although, for the good of the country I believe the FED practice of infinite money printing is detrimental, the FED demonstrates no inclination to alter their destructive monetary policies. Not even a token 0.025% increase.

  2. Michael,
    You make no mention of real estate as an alternative investment. If things are as bad as you say, it seems to me buying single and multi-unit homes offer better returns going forward. Yes, there are all the usual usual headaches of managing these properties, but there’s no shortage of people who need to rent. Thoughts?

  3. I like this asset allocation. Allas, when you need income from the portfolio to meet expenses, it will not suffice. My asset allocation is to invest in crap that provides high cash flow; junk bonds, MLPs, BDCs and try to avoid bankruptcies. On the other end I allocate about 30% to a Dogs of the Dow strategy where I reinvest dividends. For junk, my favorite is PDI. The new investment boss at Pimco is good and he’s young.

  4. The real value of gold and silver only becomes evident over time. If you bought gold during the early 70’s at $200 or less or silver at $5 or less, you understand this, but if you bought either early in 2011, you may not be so sure. Now is probably the best time during the past several years, and during the next ten years, you will realize the value of that move. The big question is how much longer can the world economy continue on its self-destructive road. Given the technology we now have and government’s willing to use it against us, some gold and silver coins and a shack out in the woods may be your best self-defense. Learn how to garden, preserve food and provide for yourself as much as possible are all excellent strategies for aintaining your freedom.

  5. Not completely out of the market Jeffrey… The UK market (LSE) has available, well diversified blue chip investment trusts with dividend yields around and above 4%. They offer the dividend quarterly and you can keep purchasing new stocks every quarter with the dividend installment. After good times and bad since 1995, I have an average annualized profit of 23% considering the amount I invested as a young man then. The suggestion to stay in the market for good dividents is not bad if you exploit the dividends. The US Dollar and the UK pound is a good investment for us living outside US, since sooner or later the serious problems of euro will become apparent. Gold, silver, US dollars, good dividend diversified portfolios, and cash will win the day. I live in the financial mess that Greece is right now and what impresses me more than this mess, is how on earth a bigger debt crises has not erupted in Italy, Spain, and the north of Europe too. Yes, I know all about the ECB’s QE program but the day of judgment is coming…

  6. I don’t think all this doom and gloom talk has any legs. No talk of options for starters. I have been returning 22% pa on options these past 2 years. My Australian div stocks currently return 10.5% while my US stocks return 7% – and my Australian bonds give me 6.7%. Paying attention to the worry-warts will only turn you into one yourself. No one knows what will happen with markets – no one ever has and no one ever will. Neil

  7. Meanwhile, im making regular returns of 20% or more. While appreciate what U R saying, everything is not written in stone. Folks simply need to do a fair of amount of Due Diligence BEFORE investing in Stocks (I agree BONDS are JUNK)–and they can propser even in the WORST markets.

  8. D Imani,
    Why would Australian bonds pay such a high rate 6.7% Are these old issues? I thought the value of the Australian dollar crashed? Well it did with regard to the U.S. dollar. Why do I know? A financial adviser some years ago recommended I hold Austi dollars…It paid off that I did not listen to that college boy! What is the reason for such high returns…in general? Not a secret that the resource industry in Australia is in the dumps? So what gives?

  9. he is correct to a degree. It is wise to have your money spread around in different things to protect against market drops. One of my investments is in two structrured settlements guaranteed by the State for %5.6 a lottery payput sold to me and legally transferred by a court .The other is an annuiity someone cashed in paying me %6.25 guaranteed by one of the biggest insurers in the world. Both come due next year when I turn 66. They were bought at a huge discount several years ago . Gold & silver make up 20%, MLP’s and higher yield make up 20%,I have an annuity guaranteeing %6 per annum with 30% for retirment invested there. It is a fabulous one where there is no market cap on what you can earn but pays out 6% . THAT is invested in two funds Black Rock Global & a great USA fund.I have stayed away from Bonds entirely and have only accummlated some cash recently. Otherwise I have been making 20-23% yearly.I’ll ladder that for the time being . I basically use three safe stocks for my “BANK ACCOUNT” The rest has been in a online bank with a 1.45% interest rate. Almost better than treasuries because it is easily accessed and insured

  10. Thank you for all your advice . Can you please clarify why you suggest to your readers to put some 205 in equities and “Absolute return strategies-20-40 percent” (which I don’t understand ) when you ALSO say the super crash is coming in a few months? Why not just gold20% and cash 80% and wait wit ammunition to get in? Thank you

  11. While there is no shortage of people who need to rent, rents are to high for most of the people who create the demand and credit checking perspective renters is a turn off, too. Apartment communities need to stop being so selfish so those that need to rent can rent without worrying about credit scores. If this and a 20% decrease in what communities are asking for rent were to occur, people who are ignored as being a part of this market could afford to rent.

  12. What a load of crap. Commodities as a safe bet?!! Other idiots agreeing with this nonsense. Cash currently offers negligible returns and inflation reduces its value. Agree with investments offering dividends. Looking over the last 3 decades or so, cylical ‘crashes’ occur but the longer left in the market, the better the returns. Wouldn’t agree with this clown. Follow at your peril

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