Justice Litle: For the 30 year period between 1981 and September 30th 2011, government bonds outperformed stocks. What does it mean? “Stocks for the long run” is a famous mantra of Wall Street. A distinguished academic, Professor Jeremy Siegel, even wrote a book with exactly that title.

The idea is that, over a long enough period of time, stocks always perform better than the alternatives (like bonds).

This is the logic behind “buy and hold” and passive index investing. If you stick with stocks, you will always come out ahead (or so they say). According to Professor Siegel, stocks have delivered better returns than bonds in every thirty year period dating back to 1861… except for the most recent one.

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As of September 30th, 2011, the thirty-year winner was actually bonds!

From 1981 onward, long-term government bonds averaged 11.5 percent per year, according to Jim Bianco of Bianco Research. The S&P 500 averaged just 10.8 percent. (These numbers don’t account for inflation.)

“The generation-long outperformance of bonds over stocks has been the biggest investment theme that everyone has just gotten plain wrong,” Bianco told Bloomberg. “It’s such an ingrained idea in everyone’s head that such low yields should be shunned in favor of stocks, that no one wants to disrupt the idea, never mind the fact that it has been off.”

It’s hard to swallow when you think about it. The year 1981 was almost the perfect time to buy and hold stocks. The greatest bull market ever kicked off in 1982, leading to the longest period of peacetime expansion in U.S. history.

And yet, over the past thirty years, bonds won. How?

Along with the ups come the downs. After the red hot 1990s came the dot com and telecom bust… and then the housing bust and subprime financial crisis… and then 2008, the euro zone crisis, and so on.

In other words: Buy and holders were crushed by a string of financial crises, while government bonds (as a place of safety) continued to do well. Equity valuations soared on the back of credit expansion and leverage across the spectrum, but then plummeted to earth as the credit boom cracked up.

Does this mean it’s time to buy bonds? No. But it is time to understand why volatility — which means big swings in equity markets — is here to stay…

The No Growth Problem

In his latest Investment Outlook, “bond king” Bill Gross of PIMCO asks and answers an important question. To paraphrase:

Q. Can you solve a debt crisis with more debt?

A. As long as the policies generate growth.

To put it another way: It is not just about what is borrowed, but how the money is invested that counts.

For example: Imagine a small business owner with a $50,000 income and $250,000 worth of debt.

If this owner borrows another $25,000 to invest in the business, and that investment doubles the net income from $50K to $100K, then he (or she) is better off than before. The borrowing was productive; it helped generate profits.

But if the borrowed $25,000 is invested poorly, or spent on frivolities, the situation changes for the worse. Now there is no change of income and a larger debt burden than before.

The major Western economies are trying to “solve a debt crisis with more debt” in similar manner to a strapped business owner borrowing to invest. The hope is to “grow” their way out through productive investment.

But this is not what’s happening. Growth is stalled, and the new debt is unproductive. Governments are throwing good money after bad. Borrowing more just adds to the burden, without increasing net income (growth).

The above chart, from PIMCO and the IMF, tells the story. The dotted line is a 5 year trailing average of economic growth for the “G7″ countries: France, Germany, Italy, Japan, the U.K., Canada, and the United States.

For the past decade, growth has been trending down (and now hovers above zero). This has occurred with total debt levels sharply rising.

It’s a sort of “treadmill to hell,” to borrow a Jim Chanos term: The West (and Japan) has been borrowing more and more, with ever weaker growth results. Piling debt on top of debt has only increased vulnerability to crisis. And an ongoing eruption of crises has increased the need for emergency stopgap measures, which only make the debt burden that much heavier. It’s a vicious circle.

The Growth/Volatility Connection

Bonds have done well during this time because growth has been so poor. When growth is slow or absent, interest rates stay low, and boring old bonds become an attractive hiding place. Uncle Sam is still a favorite, even though his credit is no longer triple-A.

As of this writing, the yield on 10-year U.S. treasuries is below 2.4%. That is a darkly pessimistic forecast in terms of economic growth. As a predicting mechanism, bonds are saying that growth will stay low for years to come.

“Growth is the elixir that seems to make every ache, pain or serious ailment go away,” notes Bill Gross. “But growth is the commodity that the world is short of at the moment… no country has enough of it…”

In a world with little to no growth, Mr. Market has strong manic depressive tendencies.

There is euphoria and explosive emotion when “hope” comes in the form of better than expected news — “maybe growth will come back!” Then there is darkness and pessimism when a new wave of crisis hits — “Maybe we’ll never get out of this.”

In trying to game the future, we can be certain of a few things:

• The total debt burden will keep increasing.
• The leaps from euphoria to despair will keep wrenching markets back and forth.
• “Buy and hold,” without significant modifications, is a dangerous strategy.

Fortunately, you don’t have to be a victim in all this. You can recognize the landscape for what it is, and prepare for the ongoing volatility in stocks (as euphoria and despair push the market in both directions).

You can even utilize strategies to take advantage of the situation, rather than hiding out in bonds for a lousy 2.4% yield (which could well be a negative after inflation).

Written By Justice Litle From Taipan Publishing Group

Justice Litle is the Editorial Director of Taipan Publishing Group, Editor of Justice Litle’s Macro Trader and Managing Editor of the free financial market news e-letter Taipan Daily. Justice began his career by pursuing a Ph.D. in literature and philosophy at Oxford University in England, and continued his education at Pulacki University in Olomouc, Czech Republic, and Macquarie University in Sydney, Australia.

Article brought to you by Taipan Publishing Group, www.taipanpublishinggroup.com.

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