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Farr: Stocks Vs. Bonds

On the day of another move by the Federal Reserve designed to lower longer-term interest rates, it is worth taking a step back and looking at the stock and bond markets over the past decade or so.

If you're like us, you believe that we may be in the waning stages of a very long bull market in bonds. The yield on the 10-year Treasury note has gone from a high of nearly 16% in September, 1981, to an historical low of about 1.93% today. While the decline in rates has not been in a straight line, the trend has been incredibly consistent for the past 30 years. The reasons for the decline in rates is beyond the scope of this note.

Suffice it to say that the major cause is that investors have come to believe that we have slain the inflation beast which wreaked so much havoc when Jimmy Carter was in office. It remains to be seen, however, whether or not the beast has been laid to rest for good. Many very credible economists believe that the Fed's policies will act as Dr. Frankenstein and resurrect the beast in years to come.

Stocks, on the other hand, have been incredibly volatile over the past several years.

The ebbs and flows have been nauseating at times, but they have created opportunities for long-term investors along the way. However, buyers of the S&P 500 index in July 1998 have not seen their nest eggs grow by much over the past 12 years. The weak long-term returns and ceaseless volatility that have characterized the stock market over the first part of the new millennium have left a bad taste in investors' mouths. Many have sworn off stocks as they instead pile their savings into "safer" bonds and hard assets like gold. Is this the right thing to do at this stage?

Every investor's goal is to "buy low and sell high."

If this is the goal, we question whether or not those who are selling stocks and buying bonds now are making a wise decision. Consider the chart below. It shows the dividend yield on the S&P 500 and the yield on the 10-year Treasury note over the past 13 years. As discussed above, the yield on the 10-Treasury has continued to trend lower, helped along more recently by the European crisis and by the Fed's endless programs aimed at cutting mortgage rates. What is more interesting, though, is that for just the second time in many years, the dividend yield on the S&P 500 is now greater than the yield on the 10-year Treasury. Think about that.

Let's say you have only two options: 1) you can own the stocks in the S&P 500 and benefit from their higher yields, future growth, and the strongest balance sheets in decades; OR 2) you can own an obligation of the over-indebted US government and subject yourself to not only credit risk but also massive interest rate risk. In our view, the choice is clear for the LONG-TERM investor.

While the valuation call favoring stocks over bonds is quite strong, in our opinion, there are also considerations that must be examined. Most importantly, we question whether or not there is the political will to continue driving down longer term interest rates. Not only is there dissention within the Fed about continued monetary easing, but Republican Congressmen sent a letter to Chairman Bernanke expressing their belief that further action by the Fed may be detrimental to the economy in the longer term. These constituencies are worried about the Fed's ability to unwind their actions, and whether or not the beast of inflation may be the inevitable result of such monetary largesse. Is the Fed truly independent of political interference?

We must note that several renowned investment gurus, including Bill Gross, made this same argument several months ago regarding the relative attractiveness of bonds and stocks. They have been wrong so far. However, our call is not a short-term trading call. "Investors" put money to work for many years; "traders" are more concerned with quick money. We think that long-term investors will be best served by overweighting high-quality stocks and using bonds as a portfolio anchor for stability and income.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.