Why bonds may beat stocks over the next ten years . . . written 2005(!)

Keith Wibel, an investment adviser at Foothills Asset Management in Tempe, Ariz., has an article in Barron's (paid subscription required) which argues that bonds might well beat stocks over the next decade. Here's his reasoning, followed by some quick comments and how to translate his views into practice using ETFs:

• The long-term rate of earnings growth is about 6.1%.
  
• S&P 500 earnings are currently (end-'04) $58.55.
  
• In a decade, S&P 500 earnings will likely be about $105.85.
  
• Earnings have flucuated by about 2.3% annually around their long-term growth rate.
  
• So in 2014 earnings will be in the range of $85.02 to $131.17.
  
• Over the last 55 years, the US market's P/E ratio has averaged 16.4.
  
• The market's P/E ratio has fluctuated by plus or minus 7.0 times earnings during that period.
  
• So in the 2014, expect a P/E ratio of 9.4 to 23.4 times earnings.
  
• Combine the earnings and P/E ranges, and the 2014 value for the S&P 500 falls out at 761.59 to 3069.14.
  
• That would imply an average return of minus 1.7% per year to plus 12.2% per year for the next decade.
  
• "The base case scenario calls for the S&P 500 Index to be at 1735.94, a yearly 4.1% rate of appreciation. Adding dividend income of 1.9% to the appreciation yields a total return of 6.0% per year -- something between minus 1.7% and plus 12.2% a year."
  
• Given that 10 year Treasuries are currently yeilding 4.2%. That's only 1.8% less than the expected return on stocks, yet exposes investors to less risk and volatility.
  

Mr. Wibel's conclusion is that investors should opt for balanced stock-bond portfolios, and should expect lower returns than has historically been the case. And he adds that investors heading into retirement will need 20% more savings if expected returns are 6% rather than 8%.

A few quick comments on this. Mr Wibel avoids any fundamental analysis. But others have used his reasoning, in combination with fundamental analysis, to come to more pessimistic conclusions. Jeremy Grantham, for example, has argued that profit margins (and therefore earnings) are currently way above trend, so expecting 6% growth in profits is unrealistic. And many people have pointed out that the US economy is running on borrowed money (huge trade and budget deficits), with consumer spending propped up by house price increases fueled by low interest rates, and that isn't sustainable. Any retrenchment would imply slower earnings growth and stock returns.

On top of that, the US population is aging, and that's sure to have an impact on economic growth. See Alan Greenspan's recent comments on this, for example.

If you're convinced that US stock returns will be meagre over the next decade, what's the best way to invest?

• Keep your investment costs extremely low - ETFs are a good way.
  
• Buy index ETFs that track emerging markets, since they are expected to produce higher returns than US stocks. Look at EEM and VWO.
  
• Make sure your portfolio includes bonds as well as stocks. You can do that with ETFs as well: look at SHY, TLT and TIP, for example.
  

Source: Seeking Alpha