Mike, the latest Ben Stein:
Sleep More Soundly With Short-Maturity Bonds
By Ben Stein
Special to TheStreet.com
01/09/2002 09:02 AM EST
All righty, now. For the most part, the stock market has continued its strange rise. When I wrote this, the price-to-earnings ratio of the Dow Jones Industrial Average was above 28, higher than at any other time in the postwar era.
It is higher by a factor of more than two, compared with its average in the 1950s, the last time we had such low inflation and such low short-term interest rates. It's far higher than it was in the 1960s, the last time we had such a big growth in productivity -- and a time of an unsustainable bubble.
The P/E for the S&P 500 stands at 41.4, by far the highest on record in the postwar period and about double the P/E of the highest year before 1999, which was 1961, when it hit 21.7. By the way, after the S&P hit a P/E of 21.7 in 1961, it took 30 years for the P/E to get that high again.
The S&P Industrials, not quite as broad an index, sports a P/E of about 53, which is an all-time high, and the Dow Jones Utility Average has a P/E of 46, which is close to an all-time high as well. Of course, as I have so painfully noted, the P/E of the Dow Jones Transportation Average cannot be calculated at all because there's no E with which to calculate it. But let's let that rest for a week and go on to something else.
A Qualified Yes
I get a lot of mail from readers. As long as they don't curse at me or say mean things to me in Yiddish, most of them send friendly and thoughtful notes. Lately, many of my correspondents have been asking if I like bonds in this era. The answer is a resounding, "Yes, but..."
As we all know, I think stocks are so high that returns for the next decade will be small, if not negative. (I'll have much more data on that next week.) But bonds of lengths beyond five years also scare me. It's conceivable that when the recovery comes, demand for lendable funds will rise, the prospect if not the reality of rising prices will be here, and long-term interest rates could skyrocket.
In that context, the most bizarre part of the current slowdown has been the amazing stubbornness of long-term lending rates, surely a prediction by lenders that they expect rates to go up soon -- and sharply.
For example, while the shortest-term rates at banks and brokerages for money have fallen by astounding amounts -- from about 6% on 13-week money one year ago to about 1.71% today -- long-term bond rates have scarcely budged. The Dow 20 bond yield was 7.8% a year ago, and it's about 7.3% now. That is, the yield on short-term money has fallen by 75%, while the yield on long-term loans in investment-grade bonds has fallen by about 6%. (Not 6 percentage points -- 6%.)
If long-term interest rates rise, then long-term bonds will fall in price, possibly sharply. (The price must fall to equilibrate the yield of the old and new bonds.) Thus, some fear about long-term bonds abides in my little heart.
But short-term bonds by definition are close to their payoff. Thus, their price fluctuates only a little compared with long-term bonds. Also, short-term bond funds are constantly buying new bonds, and if interest rates rise, their new bonds will bear higher yields than the old ones and will keep yields fairly current at the short end.
Getting Some Gains
Most interesting is that you can capture most of the interest rate gain in bonds as compared with cash by going out only a couple of years. That is, you can get about 3% on risk-free cash in some bank passbook and/or money market accounts, about 7.3% on very risky long-term bonds and about 5.1% on much-less-risky short-term government bond funds. You get about half of the coupon differential without sacrificing much in the way of principal risk. I have some of this stuff, in the form of the MFS Limited Maturity fund. It's not exciting, but it helps me sleep at night.
I also really like tax-free short-term bond funds. I live in California, where we have very high state income taxes. A 4% tax-free yield for me is very close to an 8% taxable yield, and this is good stuff indeed, especially if the credits are highly rated. I have some American Century California Limited-Term fund, and I like it so far. If something bad happens to it, I will let you know.
I do not foresee that these bond funds can double -- except maybe in a decade or more. In fact, they might double in about 14 years to 18 years. But at this point in my life (I'm 57), I'm much more concerned with not getting hit by another bubble popping than about missing out on a thousand points of the Nasdaq. Gain is a great thing, and capital appreciation is also a great thing. But asset preservation sounds nice, too.
I still have a lot of stocks, but I am getting out of them as a percentage, little by little, and going into safer items. If you have an investment horizon of less than 20 years, you might want to think about whether you can absorb another debacle like the one in 2000-2001 or the worse one from 1966 to the mid-1980s. How would you feel if your investment portfolio fell by one-third and stayed down for 20 years? Then maybe think about bonds of short maturity.
Next week, I'll discuss why the usual stock valuation models, compared with bond valuation models, are deeply screwed up at this point. |
