The Dawn of a Golden Age for Bonds


By Christopher Farrell The Enron virus is working its way through the stock market. Investors are punishing companies with opaque financing or questionable accounting -- and not just upstart telecom companies but also blue-chip stalwarts such as IBM and General Electric. Management is getting the message. GE is the latest to publicly embrace greater financial openness by promising to provide investors with more detailed numbers than ever before on its 26 businesses.

The stock market will regain its footing as investors eventually become confident again in the quality of corporate earnings and as the economy strengthens. Still, equity investors are likely to be disappointed with the returns they'll earn over the next several years.

They could find solace in bonds, however, which should offer very competitive returns with equities. Even though stocks have bested bonds for all 20-year time windows over the past 160 years, the global fixed-income research group at Deutsche Bank assigns a mere 37% probability that equities will outperform bonds over the coming 20 years.

HISTORY LESSONS. The outlook for the stock market appears bleak when compared with its sizzling performance of the past two decades. The dividend yield is a traditional measure used for forecasting long-term stock market returns. On the Standard & Poor's 500-stock index, the dividend yield has averaged 3.5% over the past half-century. But the great bull market of the 1990s drove equity valuations into the stratosphere, pulling the dividend yield lower. It now hovers around 1.3%.

The historical record shows that eras of low dividend yields are typically followed by a period of anemic returns, and vice versa. The low dividend yields of the mid-1960s preceded the poor returns of the 1970s, and high dividend yields in the 1970s paved the way for the 1980s boom. The stock market could stumble along until the dividend yield returns to a level closer to its historic norm.

Another way to predict the course of equities that has worked in the past is to combine the average dividend yield with the average growth rate of the economy. That gives you a reasonable estimate for inflation-adjusted returns for equities. The U.S. economy has averaged an inflation-adjusted growth rate of 3.4% a year over the past half-century. Going forward, economists at the Federal Reserve Board calculate the speed limit of the U.S. economy (growth as strong as it can be without igniting inflation) is a comparable 3.5% to 3.75%. Adding together a 1.3% dividend yield and a 3.4% real growth rate suggests a reasonable forecast for real stock returns is around 5%.

DEFLATIONARY FORCES. Of course, that's well below the average 12.57% annual inflation-adjusted return from 1981 to 2000. A number of factors came together to create that stellar performance, ranging from the end of the Cold War to the rise of the Information Age to a sound mix of monetary and fiscal policies. Most important was a secular decline in inflation from double-digit territory to low-single figures. The consumer price index, the broadest measure of inflation, is up a mere 1.1% year-over-year so far in 2002, the slowest pace in 15 years.

Competition continues to heat up throughout the economy, thanks to the spread of capitalism around the globe. With deflationary forces gathering momentum -- from Silicon Valley to Shanghai -- companies will find it well nigh impossible to raise prices. "Inflation rates in G7 nations [the world's seven largest industrialized countries] are at levels that are unlikely to fall much farther in the future," according to "The Bond Is Back: Bonds, Stocks, and the Price of Risk," a Deutsche Bank report.

At some point, that low inflation begins to erode the ability of companies to increase earnings. "What's more, it is far from clear that additional disinflationary pressure from here would enhance equity returns, as the associated margin pressure would likely eat into earnings," the report says.

RELATIVELY ATTRACTIVE. As a rule, bonds do well when inflation is tame. Investors can currently lock in a 3.5% return on a U.S. Treasury inflation-protected security that matures in 2029. That's a hefty return with no credit or inflation risk. Blue-chip corporate bonds are also relatively attractive these days when compared with equities.

Sure, stocks beat out bonds by some six percentage points over the past half-century. But over the next few years, investors might want to ease up on their stock holdings and put that money to work in the bond market. It's reasonable to expect that returns for stocks and bonds should run neck and neck in the first decade of the 21st century. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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