Note: This article was updated on July 28th
GMO's Jeremy Grantham has some mighty interesting company making the case that stocks, not bonds, are the more compelling investment going forward. Legg Mason's Bill Miller along with Southeastern Asset Management's O. Mason Hawkins and G. Staley Cates are also on the record that stocks offer historic value right now. And it's not just the stock guys talking their book. PIMCO bondmeister Bill Gross has also been talking up stocks. That's a pretty impressive cadre of money managers who aren't expecting the death of stocks anytime soon.
Grantham: High Quality Blue Chips Better than Bonds
In Grantham's second quarter shareholder communiquÃ© the firm's 7-year forecast still pegs high-quality large U.S. firms as a sweetspot for investors, with a forecasted annualized real rate of return of 7.3 percent for the 7-year stretch. By comparison, the firm's outlook for U.S. government bonds is 0.1 percent. Those real returns are after accounting for a forecasted 2.5 percent inflation rate.
Miller's Tale: Stocks a Once in a Lifetime Opportunity
To be sure, Legg Mason's Miller has a long-way to go working off the tarnish of massive 2008 losses, but his longer term record still makes him worth listening to. (Larry Swedroe and Allan Roth probably don't agree.) In an early July note, Miller made his case (PDF) for compelling large-cap stock valuations:
It is almost a tautology in capital markets that the best investments are those with the worst previous returns, where expectations are low, demand is down, and prospects appear at best highly uncertain. In 1980 bonds had been through a 30 year bear market relative to stocks, inflation was soaring, yields were at historic highs, yet expected to go higher, and a long bull market in bonds was at hand. The idea that U.S. interest rates would be near all time lows 30 years later would have been dismissed as ludicrous. The situation is now reversed, with stocks having underperformed bonds for decades. The point here is simple: U.S. large capitalization stocks represent a once in a lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951. I was 1 year old then, but did not have then sufficient sentience or capital to invest. I do now, and if you are reading this, so do you.
Longleaf's Take: Stocks a 'Superior Opportunity"
Southeastern Asset Management runs the Longleaf funds. Like Miller, Hawkins and Cates had a horrific time managing the flagship Longleaf Partners fund through the bear market, when it lost 50 percent. It rallied in 2009 and its 10-year annualized gain of 5.3 percent is still well ahead of the -0.79 percent loss for the S&P 500. Given their long-term record I am always interested in their perspective. Here's what they had to say in Longleaf's second quarter shareholder letter:
Equities offer a superior opportunity for investors today, particularly compared to fixed income....If earnings grow organically from today's depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor's five year average annual return will be in the mid-teens.
By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce. When stocks have been at their lowest levels, earnings yields have been an average of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks' relative attractiveness to bonds at bear market lows. We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one.
[Download a PDF of Longleaf Partner's Q2 letter to see a run through historic earnings yields at market lows vs. investment grade bonds]
Gross: Making a Case....for Stocks
Bond empire PIMCO launched a new global value stock fund this spring, and Bill Gross has been out and about talking up the fact that stocks may represent the better value than bonds In a recent Nightly Business Report interview Gross focused on tamping down bond expectations:
I think the best days [for bonds]are over. And that means, simply, that the days of price appreciation in terms of bonds added to the yield, which in many cases produced double-digit types of years in bonds are over. It doesn't mean that bonds will go down in price and that the 3 to 4 to 5 percent yields available to investors through Pimco funds and others aren't attractive in a very low-growth, low inflationary environment. I'd stick with bonds. If you're a retired investor, if you're looking to accumulate funds with safety going forward, then bonds still make a lot of sense. But the double digit returns, not just in bonds, but in stocks, are over in my view.
Gross makes a very important point: Bonds are the vital core of a retiree's portfolio. Just don't expect them to generate the same juicy returns as they have over the past 20 years. At the same time, stocks deserve a small place in a retiree portfolio. Gross isn't suggesting stocks will do gangbusters going forward, just that on a relative basis we're probably looking at a return to the more normal relationship where stocks outperform bonds. Grantham, Miller and the Longleaf team are a bit more optimistic for stocks. If like most investors you've hightailed it out of stocks and into bonds the past few years, you might want to consider the advice of some pretty smart money managers and give stocks a proper place in your long-term portfolio.