Most bond investors fear the effect of rising interest rates once the economy gains traction. The usual reaction is to shift the portfolio mix away from bonds and more toward stocks. But what if interest rates should rise, not because of increased corporate demand for loans in an improving economy, but because the Fed puts the money supply on steroids as a way of heading off deflation? Couldn't this sink the dollar, drive out foreign savers and stimulate inflation fears. In such circumstances, one could easily imagine higher interest rates, stagflation, falling corporate profits and falling stock prices even as bond prices were being pummeled. Advisors who assumed that stock and bond returns are not correlated could be in for a shock. Regardless of whether they had positioned retirement portfolios as 60/40s or 30/70s, many of their clients would be updating their resumes, looking for ways to cut their living expenses ... and possibly interviewing advisors as well.

Can We Trust The Facts?

After three years of crushing stock price declines, it would be easy to assume that U.S. equities must be on sale. We derive a lot of conviction from the historic facts; since the end of 1925 stocks have returned an average of 10.2% a year (Ibbotson), eclipsing the 5.9% average for long-term corporate bonds. Surely we can build our strategies on this historic fact. After all, the 77-year period included a worldwide depression, two world wars and the recent ruthless three-year bear market. The record suggests that now is not an appropriate time for changing investment theories; those who stay the course and refuse to panic will surely be rewarded as they have been in the past.

William Faulkner was no economist (for which he was probably most grateful), and was making a very general observation about life when he said, "I don't care much for facts; am not much interested in them. You can't stand a fact up; you've got to prop it up. When you move to one side and look at it from that angle, it's not thick enough to cast a shadow in that direction." I respect Faulkner as a canny observer of human nature, so this got me to thinking about the facts of stock and bond returns and the approach to portfolio diversification that we have built upon those facts.

The 10.2% and 5.9% figures for 77 years present a rather compelling case in favor of stocks as the long-term asset class of choice. And the 38% plunge in large stocks the past three years is adequate evidence of their short-term risks. These are the facts that support the 60/40 approach to portfolio diversification. But if we look at them from a different perspective we may identify with Faulkner's skepticism. For example: from the end of 1980 through 2002, a period of 22 years or roughly a generation, returns from stocks edged out bonds by a measly 0.3% per year (12.2% vs. 11.9%).

What if we exclude from consideration the anomalous data from the'20s bubble and the Great Depression? That leaves us the latest 60 years of performance information. In the first 30 (1943-1972) stocks returned +13.5% a year, overwhelming bonds (+2.7%) by a whopping 1,080 basis points a year. Now that is casting a big shadow. But in the second 30-year stretch (1973-2002) the story was remarkably different, with +10.7% for equities and +9.3% for Treasury debt, a spread of only 140 basis points.

When the folks at Bank Credit Analyst looked over the historic data recently, they concluded that the only great era for stocks was the 1950s and 1960s. And that, they said, was because the period started with cheap stocks (seven times earnings) and expensive bonds (2% yields). Today one could argue that both asset classes are expensive; it seems appropriate to wonder how that will influence stock/bond relationships in the years ahead.

Changes Galore

Well, if historic stock and bond relationships provide little guidance for our investment strategy, what other fundamentals are up for grabs? Plenty, it turns out: inflation, earnings, productivity, demographics and foreign trade, to name a few.

Since Paul Volcker grabbed inflation by the lapels more than 20 years ago, keeping the general level of prices subdued has been the Federal Reserve Bank's primary mission. But in the last six months, despite a CPI that seems to be hovering in the safe/normal 2% to 3% range, no less than three prominent Fed members have announced plans for dealing with deflation. In an effort to explain what is spooking the Fed, the April 25 issue of Grant's Interest Rate Observer highlighted a chart produced by Dresdner RCM Global Investors showing 45 years of a "non-financial corporate price deflator." Except for the OPEC-dominated 1970s, this inflation index has been largely contained between 0% and 4%. In the past two years, however, it has ranged from 0% to -3%. I hope you noticed the minus sign. Apparently the Fed has.

And then there are earnings. Since stocks represent ownership of businesses, the profit that those businesses are capable of generating has always seemed to have at least some relevance to the value of stocks. Over many, many moons, price/earnings ratios for U.S. publicly traded stocks have ranged widely and erratically between, say, 7X and 20X, averaging something like 15X. At this writing, the S&P 500 trades at 32 times the latest 12 months' earnings. If that were all the information we had, one would feel justified in suggesting the market looks rather expensive in terms of its historic experience.

As we know, earnings have been depressed of late, what with a recession, a war and a scandal or three. Because earnings have always bounced back in our resilient economy and gone on to unprecedented heights, many among us believe that an optimistic 12-month forward estimate of "recovery earnings" is the appropriate denominator. Calculated this way, I am told, the market P/E is a more typical 16X, not anything to be afraid of. Compared with the ten-year Treasury yield (the so-called Fed Model) some say it is a bargain.