INVESTING NEWSLETTERS

by A. Gary Shilling
I
n Fyodor Dostoyevsky’s epic novel, The Brothers Karamazov, the Grand Inquisitor
during the Spanish Inquisition visits Christ, who is in jail in Seville. He tells Jesus that he
has it all wrong. Mankind doesn’t want the freedom of conscience that he offers, the
ability and right to make moral decisions and choose between right and wrong.
Oh, no, Torquemada proclaims, humans want to be directed, they want bread, miracles
and authority. Those, of course, are the three temptations that the devil offered to Christ
during his 40 days in the wilderness, right before he starts his ministry. Satan cites Old
Testament passages that would justify Christ’s acceptance of all three offers. But Jesus turns
him down thrice, citing opposing passages.
Similarly, most modern investors want bread—the material rewards of portfolio gains.
They also want miracles performed by investment wizards who divine the inner workings of
investment markets and can perform tricks to investors’ advantage. And they certainly want
the authority of well-defined economic and security market relationships and cycles.
I can’t do much to talk investors out of the zeal for bread and miracles. They’re probably too
deeply ingrained in the human mind. But I can point out that many of the components of the
authority they yearn for aren’t working in today’s investment climate, if they ever were valid.
In this report we explore eight of these investment myths.

1. Stocks Are Superior Investments In The Long Run

They are indeed because of long-term economic growth and the parallel growth in gross
corporate product, which is essentially corporate sales. Although other sectors of the
economy, such as unincorporated business, government spending and financial transactions,
are significant, corporate revenues are involved in most aspects of the economy and therefore
closely linked to GDP. In the post-World War II era, nominal GDP grew at a compound rate
of 6.49% while GCP rose about the same rate, 6.66%.
In the long run, corporate profits rose at about the same rate as nominal GDP and GCP as
revenues, after deducting costs, dropped to the bottom line. In the 1947-2015 years, corporate profits
as defined by the Commerce Department, rose at a 6.74% annual rate and 6.11% for S&P 500 earnings.
That S&P reported earnings gain was below both the growth in GDP and GCP, which is
puzzling because of the upward survival-bias in the S&P 500 index that we’ll discuss later.
Also, you’d expect earnings by any measure to grow faster than the economy due to operating
leverage as sales rise and spread fixed costs over more units of output, to say nothing of
financial leverage. And financial leverage as reported on corporate balance sheets will be
increased by new regulations requiring companies to add to their liabilities their huge leases
on real estate, airplanes, office equipment, etc., which are effectively debt. Furthermore, the
corporate sector’s share of GDP has grown on balance in the post-World War II years.

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Profits, The Residual
As a residual, profits—the difference between corporate revenues and costs—are obviously volatile.
So, on a short-term basis, the growth in Commerce Department corporate profits and S&P
reported earnings per share varies widely from the rise in nominal GDP. Profits are also influenced
by the trade-off between the share of national income received by business and that which goes to
employee compensation. In a democracy, neither labor nor capital gets the upper hand
indefinitely, so the two shares swing from one extreme to the other as mirror images.
Real economic growth has been very slow and inflation absent, with deflation reigning in the
goods sector. So the normal source of profits gains, revenue growth, has been missing with little
unit volume growth and no pricing power.
In response, American business slashed costs, which spurred profits’ share of national income, a
measure of the nationwide profit margin. Since most business costs—directly or indirectly—are for
labor, employee compensation’s share saw a mirror image fall. But while profit margins remain on a
record-high plateau, advances stopped several years ago. It remains to be seen whether
business has scraped the bottom of the cost-cutting barrel or has picked all the fruit and has to wait for
more to ripen. History however, suggests that the next major move in profit margins will be down.
Still, in the long run, the growth rates for nominal GDP and profits are similar. This means that
over time, stock prices ride up with nominal GDP—except for the price-earnings ratio that
converts earnings into equity prices. In effect, long-only stockholders are relying on a rising

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economy, which makes it a plus-sum game, on average. But beyond the average result, it is a zero-sum
game. Anything that investors who outperform the market gain, underperformers lose. After all, the
average performance is the average. I doubt that many individual investors and probably lots of
institutional investors understand the simple reality that the stock market isn’t like Garrison
Keillor’s Lake Wobegon where all the children are above average.

2. Dividends Provide Safety, Regardless

Although most equity investors today concentrate on capital appreciation, dividends are an
important part of stocks’ total return. They were much more so in earlier years, so the long-run
average for dividends’ contribution overstates their current importance. Dividend yields today of
2% on the S&P 500 are distinctly below the 3% that was the floor in earlier years. Dividend payout
ratios are rising in an era of uncertain stock appreciation when investors want more return here
and now, but at 51% are still not high by historical standards.

Furthermore, investor reactions to dividends today are mixed. Relatively high dividend yields,
often in excess of the 2.6% yield on super-safe 30-year Treasury bonds, is not tempting investors
to buy energy and mining companies where earnings are plummeting and whose dividends earlier
were considered rock solid. Since the beginning of 2015, the S&P index of metals/mining shares is
down 49% while the energy index dropped 27%.

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 Swiss-based miner and trader Glencore has embarked on a debt-reduction plan of more than $10
billion, including a suspension of its dividend and a $2.5 billion share offering. Anglo American, which lost
$5.6 billion in 2015 after a net loss of $2.5 billion in 2014, has cut its dividend while taking massive
writedowns on many projects. The company plans to exit the coal-mining business and sharply curtail its
iron ore operation while cutting its mining businesses to 16 from 45, a further reduction from the 25
target announced last December. In mid-February, Moody’s slashed Anglo American’s credit rating to junk.

More Dividend Cuts

Copper mining giant Freeport-McMoRan dropped its dividend, cut capital spending and is selling
13% of its huge copper mine located on the Arizona-New Mexico border for $1 billion in order to
pay down debt. Another major miner, Rio Tinto, cut its dividend in early February as the ongoing
commodity price collapse pushed it to an annual loss in 2015. The company said it could no longer
maintain, much less steadily increase, its dividend each year and plans to halve its 2016 dividend
from 2015’s level. Similarly, last month BHP Billiton, the world’s top miner by market
capitalization, abandoned its progressive dividend policy as it slashed its dividend by 75% amidst
a $5.67 billion loss in the second half of 2015.
Ceasing to increase dividends every year, much less cutting them, has been devastating for the
miners and other commodity producers. At the same time, investors are flocking to predictable
dividend payers, especially recently as it became less likely that the Fed will raise rates this year,
and, I believe, is more likely to cut them instead. Note that after the Great Recession, the ECB and
the central banks of Sweden, Israel, Canada, South Korea, Australia and Chile all raised rates but
subsequently cut them. So the Fed would not be alone.
This year, the stocks in the S&P High-Yield Dividend Aristocrats Index—companies that have
increased their dividends every year for at least 20 years—are up 3% including dividends while
the S&P 500 index suffered a total return drop of 2.8%. The total return on the S&P Utility index
is up 6.7% year-to-date and I’ve favored utilities for years because of their attractive dividends as
well as predictable earnings based on services consumers buy in good times and bad.
Banks are not immune from dividend cuts, and big British bank Barclays just slashed its
dividend by more than 50% as it reported a loss of $552.6 million in 2015 vs. $244 million the year before.

Share Buybacks
Many companies prefer share buybacks to dividend payouts because they don’t imply long-term
commitments. Still, many announced buybacks are never completed, and the tendency is to buy
high, sell low. Buybacks are often made at stock price peaks when CEOs are feeling confident and
corporate cash is ample. In contrast, few are announced at equity price bottoms when fears of
liquidity shortages if not bankruptcy are widespread. In any event—as with dividends—investors of

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late have not been impressed by buyback announcements even though they increase earnings per
share by reducing shares outstanding. Furthermore, buybacks often simply offset stock awards to
company employees. Since the financial crisis, firms have repurchased $1.3 trillion in shares. Over
the last three years, reductions in equities outstanding have increased S&P earnings per share by
2%, as of the last quarter.

3. Follow The Buy High, Sell Low Strategy

Other factors are important in assessing the outlook for equity investments. One is for individual
investors to join corporate share buyback planners in perennially buying at stock market tops when
enthusiasm is at its peak, and bailing out at bottoms as despair reigns. After the 57% nosedive in the
S&P 500 from October 2007 to March 2009, retail investors redeemed their equity mutual funds on
balance for the next five years, and increased their investments on balance only in 2013.

As a result of this practice, mutual fund investor gains over time are significantly less than the
performance of the funds in which they invest. In 2014, the average equity mutual fund investor’s
return was 5.50% compared to 13.69% for the S&P 500 for an 8.19-percentage point shortfall. The
1994-2014 annualized S&P 500 return was 9.85%, but the equity mutual fund investor’s gain was
just 5.19%, a 4.6-percentage point gap, and over the 30 years, the numbers were 11.06% vs. 3.79%,
a 7.27-percentage point difference.

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4. Look For Undiscovered Stock Winners
I’m convinced that much of the appeal of stocks to investors lies in the gambling instinct that lies
deep within the human soul. People enter casinos expecting to win without seriously asking
themselves, who’s paying for all these fancy facilities and huge staff? Similarly, even investors who
know intellectually that they will beat the stock market only by random chance still try.
They search diligently, with the help of enthusiastic stock brokers, for undiscovered equities that
will leap ten times. And they forget or don’t know that armies of Wall Street analysts have the same
mission, and when those wizards utilize publicize their findings, the discounts in the prices of those
gems disappear. Investors love to tell their friends about the “ten baggers” they found without
revealing the success, or lack of it, in their total portfolio. The popularity of individual stock
recommendations in the financial media as opposed to broad investment strategies attests to this
gambling instinct.

5. Stock Indices Can Be Trusted And Are, Therefore, Reliable

Everyone can’t beat the market, especially with the added burden of investment fees. The ancient
Greek philosopher Heraclitus believed that change is central to the universe. “No man ever steps
in the same river twice,” he said, and it’s literally true as the water keeps moving by.
Similarly, stock indices are not fixed for all time but change as the components rise and fall in
relative market value. Just since the beginning of 2014, the weight in the S&P 500 of the energy

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sector has dropped from 10.1% to 6.6% as the collapse in oil and natural gas prices depressed that
sector’s earnings and its weight. Conversely, the bubble in tech stocks, until recently, pushed up
earnings and that sector’s weight in the S&P 500 from 18.9% to 20.7%.
Then there is the changing list of companies included in the various stock indices as equities are
added and deleted. After all, the S&P 500 contains exactly 500 companies so every time one is
added, one is axed. Since strong companies are added the losers and bankrupt ones dropped, the
S&P 500 time series as published overstates the performance compared to the results for the same
list of stocks over time. This “survivors bias” can be considerable, especially in times of business
stress, such as recently. Since December 2013, the S&P 500 index as reported with all the additions
and subtractions of companies rose 7%. But the delisted stocks fell 41.6% during that time period
(see chart on page 7).

6. Buy And Hold Is Best

The proponents of the buy-and-hold strategy note that trying to time the ups and downs of the
stock market is difficult. It can kill your performance. Well-known Wall Street observer Charlie
Ellis pointed out, for example, that from 1926 through 1996, almost all of the total gain on stocks
occurred in only 60 months, or a mere 7% of the total. Conclusion: If you weren’t aboard during
that 7% of the time, you blew it, and because you don’t know in advance when those luscious
months will occur, you’d better be fully invested all the time. Forget trying to time the market.
I first looked at this issue years ago, and wrote an article for the March/April 1992 Financial
Analysts Journal entitled, Market Timing: Better than a Buy and Hold Strategy. I updated that study for my
book, The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. You already
have a pretty good idea of my conclusion from that article’s title, but let me tell you exactly how I reached it.
From December 31, 1946 through February 2010, the Dow rose at an 8.7% compound annual
rate, including the reinvestment of dividends but with no deductions for taxes. In other words, $1
invested soon after World War II was worth $213.30 at the end of February 2010.
Performance this good might suggest that the best investment policy is simply to purchase
high-quality stocks and then either sit back and relax or leave for a long trip to Hongo Bongo, where
communications with the outside world are nonexistent. It seems to imply that investors should
keep their cotton-pickin’ hands off their portfolios; that trying to time the market by moving into
and out of stocks merely risks ruining a good thing.
Another, and perhaps most important, reason for the buy-and-hold strategy, as Charlie Ellis
noted, is that stocks haven’t appreciated in a smooth fashion, but in spurts, and the investor who is
in and out of the market risks being out at times of great appreciation. I found that if the
investor missed the 50 strongest months in those 63 years, his total annual return would have
shrunk from the 8.7% annual growth shown in the first line of the chart on page 9 to a shocking
pittance of 3.0% annual gain and only 6.6 times in appreciation.

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Bye-Bye To Bad Times
Before you conclude that, like honesty, being fully invested is the best policy, let’s consider several
alternatives. Suppose, just suppose, that an investor had the clairvoyance to be fully invested in
the S&P 500 except for the 50 weakest months in that era. I’m using the 50 weakest simply for
symmetry with the 50 strongest. Line 3 of the chart above indicates that this vastly improves
investment results. This $1 invested in December 1946 would have grown at a 15.5% annual rate to
$10,191—32.5 times the compound return of the fully-invested-at-all-times approach.
Why this vast improvement in return? It has a lot to do with the simple yet crucial fact that, after
a given percentage loss in a stock’s price, a bigger percentage gain is necessary to return to the
original price. If, for example, a stock drops 50% in price, it must then double to get back to its
starting point. Despite its simplicity, and I call it grade school math, this reality is not well
understood. By avoiding the 50 weakest months, the investor would have had much more money
to invest the rest of the time.
The benefit of being out of stocks during the periods of big market decline is even more
powerfully shown in line 4 of the chart. There I assume that the portfolio was out of stocks in both
the 50 strongest and 50 weakest months of the 1947-2010 years. As shown, the average return of
9.4% was better than the 8.7% return in a portfolio that was fully invested all the time.

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Better Out Than In
This is extraordinary—better performance even though the 50 months of greatest market advance
are excluded. It’s because the 50 strongest months witnessed less gain than the declines
experienced during the 50 weakest months. Being out of the market in the weakest months is very
beneficial, even if the investor also misses the strongest months. This fact is extremely comforting
to anyone trying to time the market since he can hardly expect to be in cash in the biggest down
months of bear markets without also being absent during some of the frequent final blow-off
months of the bull markets that precede them.
Investors could choose not only to own no stocks in the months of greatest stock market
decline, but to sell them short. Line 5 of the chart on page 9 shows the results when the portfolio
was out of the market during the 50 strongest months of the 1947–2010 era and short the DJIA
during the 50 weakest. Even if the 50 most robust months are missed entirely, the investor had far
better performance by being short the 50 weakest months than if he were fully invested at all times.
Line 5 indicates that $1 turned into $10,897—a 15.6% compound annual gain compared with the
8.7% annual gain from the buy-and-hold strategy with $1 growing to $213.3 (line 1).
The difference between an 8.7% compound annual gain and 15.6% may not seem great, but it
makes for a difference in portfolio value of 51 times in the course of 63-plus years ($10,897
compared to $213.3). Compounding is potent! This difference is huge, but it makes sense. If the
investor sells short and the stock falls 50%, he has gained one-half on the value of the stock. If he
had been long instead, he would have lost 50%. Consequently, the bear, with 150% of his starting
portfolio, is three times better off than the bull, whose portfolio has dropped to 50% of its original
value. Repeating and compounding this sort of gap over time results in a huge difference. Again, it’s
grade school math.

The Perennial Bear

Take it one step further and suppose the investor is a skeptic and shorted the S&P 500 not only in
the 50 weakest months, but also in the 50 strongest months, and went long otherwise. Despite his
error in taking exactly the wrong action in the strongest months, his short position in the 50
weakest proves to be so beneficial that he winds up with a 9.1% annual gain, more rewarding than
the perpetual bull. This, to me, makes a very powerful statement. Being negative on stocks in the
weakest times pays well even for the investor who is negative during the strongest months as well!
He could make a lot of mistakes in being bearish and still have an excellent performance.
Take it one step further and suppose the investor is a skeptic and shorted the S&P 500 not only
in the 50 weakest months, but also in the 50 strongest months, and went long otherwise. Despite
his error in taking exactly the wrong action in the strongest months, his short position in the 50
weakest proves to be so beneficial that he winds up with a 9.1% annual gain (line 6), more
rewarding than the perpetual bull (line 1). This, to me, makes a very powerful statement. Being

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negative on stocks in the weakest times pays well even for the investor who is negative during the
strongest months as well! He could make a lot of mistakes in being bearish and still have an
excellent performance.
This reality has worked for me in portfolios I manage. I’ve missed being long in some strong
stock rallies and sometimes have even been short, but my willingness to be short in bear markets
has produced overall superior returns. Also, there’s less competition in selling stocks short since
many investors consider it unpatriotic. Nevertheless, timing is still critical since bear markets tend
to be shorter and more intense than bull rallies.
The best results would obviously be achieved by the portfolio that was long in the 50 strongest
months and short in the 50 weakest (line 7). As usual, I assume the portfolio was long in all other
months, whether the S&P 500 rose or fell. Any investor clairvoyant enough or lucky enough to own that
portfolio would have seen each dollar invested in the S&P 500 at the end of December 1946 turn into
$352,310 by February 2010—a 22.1% annualized gain. Superior! The combined, compounded effect of
being long the bull months and short the big bear months is spectacular.
The moral of this exercise is clear: It’s profitable to be in stocks during bull markets, but it’s even
more profitable to be short stocks, or at least out of the market, during bear markets—even if many
of the major bull market months are missed completely.

Closet Timers
Many investors engage in market timing whether they admit it or not. Portfolio rebalancing
involves reducing holdings in sectors that have risen and adding to those that have fallen to
reestablish set sector percentages. This amounts to market timing since the underlying assumption
is that those stocks that jumped will fall in the next period while the fallen will rise. I, however, have
never understood this strategy of selling your winners and buying more of your losers. I am stuck
on the Wall Street adage, cut your losses and let your profits run. Or as Dennis Gartman puts it, do
more of what’s working and less of what isn’t.
I also eschew the buy-and-hold strategy because of what’s known in classical statistics as the
gamblers ruin paradox. The odds may be in your favor in the long run—in this case, your stocks
may provide great returns over, say, ten years. But if you hit a streak of bad luck, your capital may
be exhausted before that long run arrives. Or, more likely, a severe bear market will scare you out
at the bottom. Many investors bail out then and don’t reenter until the next bull market is well
advanced. This explains why the returns of mutual fund investors lag well behind the performance
of the funds in which they invest.

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7. Taxes Are Important In Investment Strategy
None of the data in the chart on page 9 assumes tax liability or payments, but taxes do matter to
many investors. A very wise institutional investor once told me that the best investment is one you
never sell. He was referring not only to its long-term value but also to avoiding the taxes that are
due on asset sales. So tax considerations do favor the buy-and-hold strategy since the tax money
that would be paid on periodic stock sales is, in effect, reinvested and tax liability postponed to the
final day of judgment.
Nevertheless, tax payments would not significantly offset the superior performance of being
absent or short in bear markets compared to owning stocks throughout the time period. I did learn
years ago that managing an investment account with heavy emphasis on taxes did greatly reduce
them. But it was because I stuck with investments that were going against me to the point that my
gains evaporated. No profits, no taxes!

8. Stocks Outperform Bonds

This is a widely-held belief, and stock bulls point out that since July 1982, when the secular bear
market in stocks ended, the S&P 500, including reinvestment of dividends, has had a 12.0%
compound annual rate of return. So $100 invested back then has appreciated to $4,450 today.
In contrast, the Barclays U.S. Aggregate Corporate Total Return index, which tracks a variety of
investment-grade fixed-income vehicles including Treasurys, corporate securities and mortgage-
backed securities, has had a 9.4% annual return. So $100 invested back then has risen to $1,964,
or only 44% as much as the S&P. But this comparison is extremely biased, probably because those
oriented toward stocks have a profound dislike for bonds in general and Treasury bonds, my
all-time favorite, in particular.
Full disclosure: I’ve been a bull on 30-year Treasurys since 1981 when I stated, “We’re entering
the bond rally of a lifetime.” It’s still under way, in my opinion. Their yields back then were 15.21%,
but my forecast called for huge declines in inflation and, with it, a gigantic fall in bond yields.

Treasury Haters
Stockholders inherently hate Treasurys. Shareholders say they don’t understand them. But their
quality is unquestionable. Also, Treasurys and the forces that move yields are well-defined—Fed
policy and inflation or deflation are among the few important factors. Stock prices, by contrast,
depend on the business cycle, conditions in that particular industry, Congressional
legislation, the quality of company management, merger and acquisition possibilities, corporate
accounting, company pricing power, new and old product potentials, and myriad other variables.
Stockholders also understand that Treasurys normally rally in weak economic conditions, which

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are negative for stock prices, so declining Treasury yields are a bad omen for those individual and
institutional investors who worry more about inflation than deflation and also hate bonds, which
tend to fall in price as inflation rates rise.
Wall Street denizens also hate Treasurys. Commissions on stock trades are usually much bigger
than on Treasurys, so brokers favor equities. So do investment bankers if interest rates are falling,
as I learned firsthand while at Merrill Lynch and then at White, Weld. Bankers didn’t want me
along on client visits when I was forecasting lower interest rates. They preferred projections of
higher rates that would encourage corporate clients to issue bonds immediately, not wait for lower
rates and cheaper financing costs.

They Hate What They Do

Professional managers of bond funds are a sober bunch who perennially fret about inflation, higher
yields and subsequent losses on their portfolio. If yields fall, they don’t rejoice over bond
appreciation but worry about reinvesting their interest coupons at lower yields. And if yields rise,
they complain about capital losses. Well, they can’t have it both ways!
I’ve been pretty lonely as a Treasury bond bull for 35 years. Also, I continue to favor the 30-year
bond over the 10-year note, which became the benchmark after the Treasury in 2001 temporarily
stopped issuing the “long bond,” as the most recently issued 30-year bond is called. I prefer the
long bond because the longer the maturity, the greater the appreciation when rates decline. And
I’ve never, never advocated Treasury bonds for their yield. I couldn’t care less what it is, as long as
it’s going down and, therefore, the bonds are appreciating. That’s the same reason most investors
have invested in stocks since the early post-World War II years.
Because of compounding interest, a 30-year bond increases in value much more for each
percentage point decline in interest rates than does a shorter maturity bond. At recent interest
rates, a one percentage point fall in rates in one year results in interest plus appreciation of 3.5% for
a 5-year Treasury note, 10.2% for a 10-year note and 24.8% for a 30-year bond. Unfortunately, this
works both ways, so if interest rates go up, you’ll lose much more on the bond than the notes if rates
rise the same for both.

More To Go
If you believe, as I do, that interest rates will continue to fall, you’ll want to own the longest-
maturity bond possible. This is true even if short-term rates were to fall twice as much as 30-year
bond yields. Many investors don’t understand this and want only to buy a longer-maturity bond if
its yield is higher, much higher because they only think of the interest rate return.
Others only buy fixed-income securities that mature when they need the money back. Or they
will buy a ladder of bonds that mature in a series of future dates. This strikes me as odd, especially
for Treasurys that trade hundreds of billions of dollars’ worth each day and can be easily bought

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and sold without disturbing the market price. Of course, when you need the cash, interest rates
may have risen and you’ll sell at a loss, whereas if you hold a bond until it matures, you’ll get the full
par value unless it defaults in the meanwhile. But what about stocks? They have no maturity so
you’re never sure you’ll get back what you pay for them.
It may surprise you that there’s about 16% left in this “bond rally of a lifetime.” After all, the
decline in 30-year Treasury bond yields from 15.21% to 2.6% has already been accomplished, so the
expected further fall to my 2% target doesn’t sound like much. But as you’ll note from the chart
above, the decline in yields from 15% to 14% results in 7.0% appreciation for a 30-year coupon
bond, but a fall from 3% to 2% gives a 22% gain.
I’m not suggesting that once the 2% long bond yield is reached those securities become lethal. Far
from it. With 2% to 3% deflation, the real yield would be 5% to 6%, at least twice the post–World War
II average of 2.5%. In contrast, stock performance during chronic deflation is problematic.

Zero-Coupon Bonds
Bond interest payments are important in boosting total return because of the compounding
effect. As bond yields fall, however, the interest rates on the reinvestment of the coupons
paid out decline as well. When yields were 10%, the interest received could be reinvested at
10%. At a 5% interest rate, the reinvestment earns only half as much.

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 The problem can be eliminated with zero-coupon bonds—also known as stripped bonds,
or strips, because the coupons often are separated, or stripped, from the bond itself. They
pay no interest, only one final payment at maturity. They are bought at a discount to that
fixed final price and, in effect, the current interest rate is locked in. At 5% yields, for
example, a zero coupon Treasury that matures in 30 years at $1,000 sells at $228.60 since
$228.60 compounded at 5% for 30 years equals $1,000.

By eliminating this reinvestment risk, zero-coupon bonds deliver much more bang per
buck as interest rates fall than do interest-paying bonds. On a 30-year zero-coupon bond, a
decline in rates from 15% to 14% boosts the price by 30%, and a drop from 3% to 2% leads
to 34% appreciation (chart above). By comparing the chart on page 14 to the one above,
you’re seeing two big differences between coupon and zero-coupon bonds. First, the price
increases per decline in yields for zeros are much greater, especially for long-maturity
bonds. Consequently, a yield drop from 6% to 3% boosts the 30-year zero price by 137%
compared with 63% for the coupon bond, excluding coupon payments. Second, the
appreciation for each percentage point decline in yield increases very slowly for zeros
compared with coupon bonds, due to the absence of the coupon reinvestment risk.
In contrast to the 15.9% total return on a 30-year Treasury, if the yield drops from the
current 2.6% to my 2% target, the zero-coupon would appreciate 22.7% Similarly, if the
10-year note yield falls from the current 1.8% to my 1% goal in one year, the coupon note
return would be 8.0% and 8.9% for a 10-year zero-coupon note.

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Three Sterling Qualities
I’ve also always liked Treasury coupon and zero-coupon bonds because of their three sterling
qualities. First, they have gigantic liquidity with hundreds of billions of dollars’ worth
trading each day. So all but the few largest investors can buy or sell without disturbing the
market. Second, in most cases, they can’t be called before maturity. This is an annoying
feature of corporate and municipal bonds.
When interest rates are declining and you’d like longer maturities to get more
appreciation per given fall in yields, issuers can call the bonds at fixed prices, limiting your
appreciation. Even if they aren’t called, callable bonds don’t often rise over the call price
because of that threat. But when rates rise and you prefer shorter maturities, you’re stuck
with the bonds until maturity. It’s a game of heads the issuer wins, tails the investor loses.
Third, Treasurys are considered the best-quality issues in the world. This was clear in
2008 when 30-year Treasurys returned 42%, but global corporate bonds fell 8%, emerging
market bonds lost 10%, junk bonds dropped 27% and even investment-grade municipal
bonds fell 4% in price. In today's uncertain financial markets, even high-quality corporate
bonds are losing out to Treasurys. Triple-A Exxon Mobil just issued a 10-year obligation that
paid 1.3 percentage points more than comparable Treasurys vs.0.58 percentage points last
year. Meanwhile, junk bonds, especially at the bottom of the spectrum, are having trouble
finding any buyers for their obligations.

What Is A Bond?
Equity lovers are biased against Treasurys and this is shown clearly by their comparison of
stock performance over time with the Barclays Index. They match stocks, with essentially
infinite maturity, with a fixed-income index of only 5.5 years in duration and a 4.6-year
average maturity. In contrast, a 30-year Treasury has a duration of 21 years and a maturity,
of course, of 30 years while for a 30-year zero-coupon bond, the duration and maturity are
both 30 years. To compare returns on stocks with those on the Barclays Index is like
comparing apples to oranges. Also, the Barclays Index is misnamed as a bond index to begin
with. Any Treasury bond is an issue with more than ten years’ maturity.
A much fairer comparison between stocks and bonds is shown in the chart on page 17, my
all-time favorite, as long-time Insight readers are well aware. It shows the results of
investing $100 in a 25-year zero-coupon Treasury bond in October 1981 when the yield was
at its highest and price the lowest. The results for a 30-year zero are even better but I’m
using the 25-year due to data availability. I assumed that bond is rolled over into another 25-
year zero-coupon Treasury each year to avoid the declining interest rate sensitivity of a bond
as its maturity shortens with the passing years.

W W W. F O R B E S N E W S L E T T E R S . C O M 16
 In January 2016, that $100 originally invested in October 1981 climbed to $26,117, or
17.7% at a compound annual rate. That’s six times the gain on $100 invested in the S&P 500
at its low in July 1982, or a 12.0% annual total return. It also vastly exceeds the 9.4% annual
return for the Barclays Index, which grew $100 to $1,964, as discussed earlier. In
comparison with Treasury bonds, the Barclays suffers in two important ways. First, the
yields on short maturities are normally lower than on longer obligations. Second, short
maturities have relatively little appreciation as interest rates fall.

W W W. F O R B E S N E W S L E T T E R S . C O M 17
 It’s been a volatile year so far in the market and if you think we’ve seen the
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