By Guest Blogger Doug Rowat
.
Ah, recency bias. Perhaps the most dangerous and pernicious of all behavioural investing biases.
As Covid-19 runs rampant across the US, volatility rises throughout global equity markets and the catastrophic 33% plunge in US Q2 GDP sits fresh in our minds, it’s tempting to simply wrap the entirety of one’s investment portfolio in the security blanket of US bonds.
And why not? The US is the wealthiest and most powerful nation in the world and its bonds are amongst the very safest. And in the face of all of this year’s horrible news, the Barclays Aggregate US Bond Index is up an impressive (and comforting) 13.7% y-t-d, obliterating the y-t-d total return of the S&P 500. But this is what recency bias does—it fixates investors only on the present and coerces them into thinking that what is happening now will persist long into the future.
But, naturally, such conclusions are incorrect. With recency bias undue importance is given to performance and events that have occurred, well, recently, resulting in the more predictive long-term market trends getting overlooked. And I don’t need 22 years in the investment industry to understand the powerful and misleading effects of recency bias. I live in Toronto—a hockey-mad city that succumbs constantly to it. Every brief Maple Leaf winning streak or nifty Auston Matthews goal will, in the collective mind of this city, translate to Stanley Cup glory and a parade down Bay Street.
But back to US bonds. A much more meaningful performance timeframe wouldn’t be the few pandemic-dominated months of 2020, but rather the entire previous decade. Examining this 10-year timeframe, everything reverses. From end-2009 to end-2019, on a total return basis, the S&P 500 returned 13.5% annually while US bonds returned only 3.7%.
This long-term track record is why we tilt the vast majority of our client portfolios towards equities. High-quality bonds are essential for stabilizing portfolios and controlling emotion during periods of turmoil, but this doesn’t make them worthy of being the dominant component of one’s asset allocation.
First, the obvious. US bond yields have been declining for decades and therefore overall US bond returns have been declining right along with them:
US bond returns have declined decade after decade
Source: Bloomberg, Turner Investments
We, of course, don’t know if overall US bond returns will decline this decade as well, but it’s rarely a good idea to bet against a well-defined multi-decade downtrend. Btw, US 10-year Treasury yields have declined 95% over the past four decades and if you think they won’t eventually go negative, which longer term would mean even more anemic overall bond returns, take a closer look at France, Germany, Switzerland, the UK and Japan.
Second, US bonds no longer yield meaningfully more than inflation. There was a time when their advantage over inflation was double-digit. Ancient history. Granted, the present US inflation rate is low, but the long-term inflation rate has averaged about 3%. With the US 10-year Treasury yield, for example, currently at only about half a percent, it’s unlikely that bond yields will be eclipsing long-term inflation rates any time soon. Remember: the Fed raised interest rates NINE times from 2015 to 2019 and even that streak only took the 10-year Treasury yield above 3% very briefly. Is anyone predicting nine interest-rate increases from the Fed now? A US 10-year Treasury bought now and held to maturity would almost certainly lose money after inflation.
US 10-year Treasury yield minus inflation rate: it’s becoming more and more unlikely that Treasury yields will beat inflation
Source: Bloomberg
Finally, US equity dividend yields currently provide much better value. Yes, you have to take more risk, but if a main consideration is simply income, you’re better off with equities. Again, the yield advantage for Treasuries, which was once double-digit, has evaporated. Also, historically speaking, US corporations raise their dividends 5-6% annually, so your equity dividend, unlike a bond coupon, will almost certainly grow at a faster rate than inflation. I also haven’t even touched on the preferential tax treatment of dividend versus interest income.
US 10-year Treasury yield minus S&P 500 dividend yield: equities now generate substantially better income
Source: Bloomberg
So, before you succumb to the fear created by the recent dire headlines and flee to the safety of US bonds consider the tricks that recency bias may be playing on you. The bigger picture is actually suggesting that most US bonds offer poor value at the moment.
And combating recency bias always demands looking at the bigger picture. What holds more importance? A pattern that presents itself over just a few months or a pattern that presents itself over more than four decades?
Or in the case of the Maple Leafs, more than five decades.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.