Investing Lessons from the 35 year Post World War II Period

The Bond Buyer's Dilemma is a warning about the investment suitability of bonds over the next several decades.

Although the words 'financial repression' aren't used in the editorial by renowned Princeton economics professor Burton G. Malkiel, that's exactly what he's describing. If you want a brief refresher on financial repression, please refer to the December 9 posting "Financial Repression and Government 'Can Kicking' Can Cause Long Term Problems."

In the view of Mr. Malkiel, here's what financial repression means for today's investors:

"Are we in an era now when many bondholders are likely to experience very unsatisfactory investment results? I think the answer is "yes" for many types of bonds—and that this will remain true for some time to come.

Many of the developed economies of the world are burdened with excessive debt. Governments around the world are having great difficulty reining in spending. The seemingly less painful policy response to these problems is very likely to keep interest rates on government debt artificially low as the real burdens of government debt are reduced—meaning the debt is inflated away.

Artificially low interest rates are a subtle form of debt restructuring and represent a kind of invisible taxation. Today, the 10-year U.S. Treasury bond yields 2%, which is below the current 3.5% headline (Consumer Price Index) rate of inflation. Even if inflation over the next decade averages 2%, which is the Federal Reserve's informal target, investors will find that they will have earned a zero real rate of return. If inflation accelerates, the rate of return will be negative.

We have seen this movie before. After World War II, the debt-to-GDP ratio in the United States peaked at 122% in 1946, even higher than today's ratio of about 100%. The policy response then was to keep interest rates pegged at the low wartime levels for several years and then to allow them to rise only gradually beginning in the 1950s. Moderate-to-high inflation did reduce the debt/GDP ratio to 33% in 1980, but this was achieved at the expense of the bondholder.

Ten-year Treasurys yielded 2.5% during the late 1940s. Bond investors suffered a double whammy during the 1950s and later. Not only were interest rates artificially low at the start of the period, but bondholders suffered capital losses when interest rates were allowed to rise. As a result, bondholders received nominal rates of return that were barely positive over the period and real returns (after inflation) that were significantly negative. We are likely to be entering a similar period today."

So what does that mean to the individual investor of today? Here's my take.

Bonds are likely to be a poor individual investment choice for perhaps the next thirty to fifty years. Whether fixed income holdings represent an inappropriate individual investment for thirty, fifty or even more years will depend upon how well policy makers have learned the inflation lessons of the 1970s.

What to do?

Buy a basket of blue chip stocks that pay increasing dividends instead. And if you don't want to bother with individual stocks, just buy the S&P 500 passive Index Fund. That will beat a mixture of stocks and bonds over time.

This, of course, assumes that you won't need the money immediately and thus be hostage to short term adverse swings due to recurring stock market volatility. If you're a long term investor, simply stay with the shares of good companies paying decent and growing dividends.

So beware of "experts" looking in the rear view mirror and recommending target-date funds, money market funds, balanced funds, fixed income funds and the like.

Indeed, let this serve as a warning about the conventional "expert" advice being offered concerning 401(k) and IRA defined contribution plan investing. Advice such as the following in Companies trim investment choices in 401(k)s:

"While the {typical plan investment offerings} menus are streamlined, generally they aim to offer something for everyone; at the least a cash alternative, a target-date fund for those savers who don’t want to create their own portfolio, and a brokerage window for savvier investors to access a broad array of choices.

{Investment adviser} Davis said his firm’s clients — employers offering 401(k)s to their workers — are structuring their investment menus in essentially three different tiers. One tier is comprised of target-date funds for those investors “who really would rather not make their own decisions,” he said.

The second tier is a traditional core investment menu, “perhaps a little more limited than it was in the past — a couple of stock and bond funds, large-cap, small-cap, mid-cap, international, maybe a core traditional fixed income fund and then a cash alternative,” he said.

The third tier — for retirement investors who are “more hyper-engaged with their plans,” he said — is a brokerage account window. “Those come in two flavors essentially: mutual funds only or mutual funds plus market-traded stocks and bonds.”"

Let's sum up.

What Professor Burkiel is suggesting as one alternative to traditional choices would substitute blue chip equities for fixed income investments. That makes sense.

With such a diversified blue chip equity only approach, assuming the individual investor can stomach market volatility, he will receive current cash dividends yielding as much or more than bonds. In addition, there will be the extra kicker of future stock appreciation and growing dividends as well.

That sounds good to me.

So bond buyers, beware. The heavily indebted government is not on your side. Financial repression is in play and will be for decades to come.

That's today's post World War II 35 year long investing lesson.

Thanks. Bob.