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Scott Burns Responds to the Paul Farrell Article
By JLP | April 15, 2009
I sent an email out today to several people I like and respect in the investment field, asking for their opinions on the Paul Farrell piece I wrote about yesterday. Here is the response I got back came from Scott Burns:
I certainly appreciate Paul Farrell’s anger and contempt for Wall Street. It is richly deserved. And Gary Shilling isn’t alone in having spotted a major opportunity in long bonds back in 1981. Van Hoisington also spotted it and has built a winning fixed income fund on the secular decline in interest rates. Your readers would do well to read economist Lacy Hunt, who works at Hoisington Management. Here’s a link to their most recent report.
Similarly, Steve Leuthold wrote a stunning analysis, back then, comparing prospective returns on zero coupon Treasurys (and conventional long Treasurys) against common stocks under different future interest rate assumptions. He continues to do that analysis for institutional clients today. Back then he showed that it was virtually impossible to lose investing in a 12 percent zero.
Finally, there is a growing camp in academia that advocates TIPS as the best and safest investment for most people. The best known economist in this group is Zvi Bodie at Boston University. Analyst Rob Arnott has also put in good words for TIPS over equities.
The basic argument is simple: You can get a 2 percent real return in TIPS and that’s a lot more certain than, say, a 3 percent yield on equities with an uncertain upside from growth. Factor in the destructive power of volatility (think variance sink) and a fixed income investment looks pretty good compared to equities after the last 8 years.
Shilling, however, may just be one of the first voices to echo the famed Business Week “death of equities” story in 1981 or 1982. While he’s looking forward to more of the same in equities and thinking that bonds look good, I can make a good case that this is NOT the time to invest in bonds. Shilling may be a “buy” signal.
Why? Because the same force of inflation that made bonds a terrible investment in the 60s and 70s (negative after-inflation returns) may return in the near future because governments tend to inflate their way out of problems. Not to mention the horrendous unfunded liabilities of Social Security and Medicare. Today, bond returns are barely keeping up with very low inflation. Stocks, on the other hand, are providing a higher yield and may be building book value at a rate that will keep up with (or surpass) inflation.
Other research of prospective equity returns as a function of starting P/E ratio indicates that we may be approaching a level where future equity returns are higher than average. Here’s a link to a recent column on the subject. If your readers will scroll to the bottom of the column they can download Kitces analysis in the context of portfolio survival.
Finally, it is never a good idea to hang your future on a single call— stocks or bonds. We diversify because we don’t know the future.
Scott Burns
Chief Investment Strategist
AssetBuilder, Inc.
Plano, TX
Thanks, Scott! I’m sure AFM readers will appreciate your input.
I think the key is the same key that it’s always been: DIVERSIFICATION!
Topics: Investing | 10 Comments »
April 16th, 2009 at 4:24 am
Brilliant! Well-worded, concise and looked at btoh sides of the coin.
April 16th, 2009 at 6:02 am
One solution to inflation is a well-laddered portfolio of CDs. TIPS and I Bonds have their supporters, I know, but I have yet to see any definitive studies showing that they do better than CDs. After all, CDs are merely nominal bonds issued by private entities (credit unions or banks) with essentially the same risk (zero) as TIPS or I Bonds. Sure, there’s re-investment risk if a bank or credit union goes toes-up (the new entity might not honor the rate or term), but you can build a ladder of short maturities (say, no more than four to five year CDs) and minimize that risk. You need to be mindful of the insurance limits, but that’s not usually a big issue. Worst case: you get the $$ back, with interest and no penalty, and go shopping.
Admittedly, I do a lot of rate-chasing. However, in a tax-deferred account, I’ve found over the past 2 1/2 years that my real return has exceeded that of I Bonds handily. TIPS as well, except for the time when the real return nudged into 3% territory. I’m not a big fan of TIPS funds (too volatile for retirement planning, in my view). Individual TIPS bonds, well, there’s the liquidity issue unless you have the patience to build a ladder of 5 year TIPS. And then I’m talking tax-deferred, anyway.
Anyway, I suspect the dearth of analysis regarding CDs is due mostly to the ephemeral nature of the data. There really is no accurate historical data base of the “best” CD rates at any given point in time, and rates vary widely with exogenous factors (teaser rates, “local specials”, you name it).
All I can say to fans of fixed income (and I am one) is: don’t dismiss CDs. They may not be sexy, but they can anchor the bond part of your AA.
Bozo
April 16th, 2009 at 7:31 am
Just my 2 cents…I believe the annual limits for buying savings bonds on Treasury Direct is $5,000 for paper and $5,000 for electronic. For most folks, that’s adequate. I just picked up $2,000 in I-series last week at a 5%+ rate. I was discouraged by our (taxable) on-line savings acct rate of 1.5% and figured: 1) the I-series rate is higher and 2) no taxes until maturity (and maybe not even then–see below.)
Bozo, for our situation I prefer I-series over CD’s for 2 reasons: no state income tax on earnings (3% and undoubtedly heading north here in IL!) and down the road I could even get out of paying federal tax if: 1) we use them for the boys’ college and 2) our income is low enough to avoid the tax (yes, there is a limit and it gets phased out. Right now we’d be out of luck, but in 13 years, that could change.) Even if we don’t use them for college I could hold them until we’re ripe ol’ seniors and our income would certainly be lower by then and presumably taxed at the lowest/lower rates. Or we’ll just be dead and the kids can inherit them
I’m all about depriving the government of taxes on my hard-earned savings!!
Lucky for you, Bozo, that you can save in a tax-deferred acct. Our income, coupled w/my husband’s 401k participation, prevent that unless I did nondeductible IRA contributions (which are then a nuisance to track, but doable.)
April 16th, 2009 at 8:11 am
JLP:
Great article and you have some sharp readers of your blog. They are a head and shoulders above most PF blog commenters.. Well done everybody!
April 16th, 2009 at 8:28 am
Stacey, you’re doing the very thing I Bonds were designed for, i.e., periodic and methodical savings. Bravo! Just be aware that you’re in for a bit of interest-rate shock. I Bonds are shortly going to zero (including the one you just purchased). The good/bad news is that inflation will no doubt rear its ugly head down the road, at which point you will be protected, even with a fixed component of 0.7%.
Bozo
April 16th, 2009 at 8:38 am
Few investors stuck with bonds over the last 20 years if they were looking for growth. Why? Because during some intervals, some quite long, equities trounced bonds. The only folks I know who stuck with bonds were those looking for income and they could care less about beating equities.
Many investors have extremely short performance time frames so they chase one asset class to the next.
That’s why diversification is important and having a plan is even more important.
April 16th, 2009 at 9:41 am
True, Bozo, about the rates going down. But I’m a firm believer that all these bailouts/handouts/Tarp crap is going to come home to roost. And when that happens, inflation will increase, thus our investment in the I-series. Buying bullets will be next!
April 16th, 2009 at 10:16 am
I’m a big fan of CDs myself, Bozo. Particularly brokerage callable CDs which give you a little extra interest.
One of the most valuable things I learned from Scott Burns over the years is that a 5-yr CD will outperform 90% of all bond funds over a 5 year period. The only fund which can consistently beat CDs is Vanguard GNMA. But then you have to make a bet on interest rates because of the fluctuating NAV which will ruin a good yield.
TIPs and I bonds were great when they paid 3% above inflation. But at 2%, they are marginable.
April 19th, 2009 at 3:28 pm
@Wealth Pilgrim: “Few investors stuck with bonds over the last 20 years if they were looking for growth.”
It depends. If you bought bond funds or if you didn’t have enough money 20 years ago and were buying at different times than you may be right. But I’d imagine anybody who locked 18% 20 years ago would want to sell.
@Stacey: “But I’m a firm believer that all these bailouts/handouts/Tarp crap is going to come home to roost. And when that happens, inflation will increase, thus our investment in the I-series.”
This seems to be almost obvious – that the increase in money supply that we have will cause inflation. But is it so obvious? From what I read there are two things which control inflation: money supply and velocity of money. We have ample money supply but velocity is almost non-existent. Banks aren’t lending, people aren’t buying, unemployment is increasing. A lot of money disappeared into a black whole and newly printed/borrowed money may well disappear in potential losses in commercial real estate and credit card defaults. Sure, we may get stagflation as in the 80s, but back then it was driven by rising oil prices – if I am not mistaken. Not clear if this is what will see.
I wish I could be sure that we’d have inflation, then I’d know how to invest my money. I’d be happily convinced of this since I really don’t know the best way to allocate my money nowadays.
@RA: “One of the most valuable things I learned from Scott Burns over the years is that a 5-yr CD will outperform 90% of all bond funds over a 5 year period.”
I don’t know if it makes sense to lock today’s rate for 5 years. There is not much room for the rates to decrease. Now when the rates do increase, the money in bond funds would lose value, so a 5 year CD can still outperform.
But is it a valid comparison? A CD is a fixed income investment. A bond fund is not – its value fluctuates with value of bonds on secondary market. So wouldn’t a comparison with individual bonds be better? Not only government, but also municipal and corporate. Yes there is risk with investing in municipal bonds and corporate bonds, but it is a smaller risk than with stocks.
April 20th, 2009 at 11:48 am
Kitty: “But is it a valid comparison? A CD is a fixed income investment. A bond fund is not – its value fluctuates with value of bonds on secondary market.”
Yes, Kitty. It is a valid comparison. Because you can invest in a bond fund or you can invest in a CD. Since investing in a CD beats a bond fund 90% of the time, it is best to stay away from bond funds and just go with the CD.
I’m not suggesting anyone lock in a 5-year CD at this point. But if I was going to invest in a bond fund or a CD, I’d go with the CD. At this point, I wouldn’t do either.