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Stocks vs. Bonds: Stocks Win

Here are two investments I’d like you to consider. The first is a Treasury bond maturing in 10 years. The second is the Standard & Poor’s 500. Think you already know everything there is to know about them? Think again.

Let’s start with the bond. As of Thursday’s close, it was priced to yield 4.07%. If you hold it for 10 years — until the day it matures — that’s your guaranteed return every year, locked in the day you bought it. It can never do better than that, and it can never do worse. At the end of the 10 years, you get your initial investment back, guaranteed.

You’ll pay taxes on that yield every year as it’s paid out. Just for illustration, let’s say you pay federal income taxes at a 25% rate (there’s no state income tax on US government-bond income). That means the after-tax return from your Treasury bonds each year will be 3.05%.

Right now the inflation rate as measured by the “core” Consumer Price Index is 2.19%. That’s pretty low by historical standards — about half what it’s been on average over the last half century. And the core rate doesn’t even include food or gasoline (which may be a problem if you’re the kind of person who drives a car, or eats). But even that’s enough to lower the after-tax, after-inflation yield from your bonds to only 0.86%.

Now let’s consider the S&P 500. Its yield is 6.48% — far higher than the 4.07% yield of Treasury bonds. Wait, you’re surely asking how I can claim the S&P 500’s yield is 6.48% when currently dividend payouts only come to 1.84%? It’s simple. Dividends aren’t the only form of yield that stocks provide to investors.

Dividends are less than half the yield story for stocks. They are just the portion of a company’s earnings that it pays out immediately to stockholders in cash. The rest of a company’s earnings are retained by the company, either in the form of cash or in the form of investments that help the company to grow. As a stockholder, you own a piece of all earnings, not just the part of them that are paid out. All else equal, what doesn’t get paid out makes the stock price go up by the amount that would’ve been paid out.

That suggests some interesting tax situations. You pay taxes immediately on those earnings that are paid out as dividends. The maximum federal tax rate on dividends is only 15%, and dividends are treated differently by all the states. So for many investors, depending on residency, the tax treatment of dividends is favorable relative to that of bond income.

The earnings that you receive in the form of stock-price appreciation — as opposed to dividends — are only taxed if and when you sell the stock. That means that the money can compound tax free for years and years, which can add up to a huge advantage. When you finally do sell and realize the gain, it will be taxed at capital-gains tax rates, which at the federal level are capped at only 15%, and are treated differently state by state. Considering the compounding feature, you’re almost sure to get better tax treatment on capital gains than you would on bond income.

But where stocks really shine is as protection against inflation. It’s far from exact, but generally speaking corporate earnings should grow with inflation. If a company sells apples, and the price of apples goes up by 30% over 10 years because of inflation, you can be pretty sure that the company’s earnings will go up 30% too, all else equal.

So let’s do the numbers.

Just to be conservative, let’s assume no tax advantage for the earnings yield of stocks compared to the income yield of bonds. So we’ll reduce 6.48% by 25% to get 4.86%. Now should we subtract the inflation rate of 2.19%, like we did for bonds? No, because I’m going to assume that earnings will grow at the rate of inflation. That’s a conservative assumption, by the way. Historically, they’ve grown more.

So, using two conservative assumptions, we are left with an after-tax ,after-inflation yield on stocks of 4.86%. That’s more than the pretax, pre-inflation bond yield of 4.07%. And it’s a lot more — better than five times more — than the after-tax, after-inflation bond yield of 0.86%.

So let’s say you have $10,000 to invest. Put it in bonds, and at the end of 10 years your after-tax, after-inflation compounded gain will be about $920. In stocks, it’ll be about $6,070.

OK, OK, let me deal with the obvious objection to this analysis. At the end of 10 years, there’s no guarantee you’ll get all your money back in stocks, whereas with bonds it’s a sure thing. That’s certainly true. But the historical record suggests that there are very, very few 10-year periods in which you’d lose any money at all in stocks. Considering the expected advantage to stocks here, for investors who really can think in terms of time horizons 10 years or longer, it’s a risk well worth taking. Candidly, I don’t really think it’s a risk at all.

What if you’re going to hold for less than 10 years? Well, that changes things. The shorter the holding period, the greater the risk there will be some crazy short-term fluctuation that will cause you to take a loss in stocks at some particular moment in time. But bonds aren’t immune from that risk by any means. If you hold a 10-year bond for less than 10 years, there’s no guarantee whatsoever that you’ll be able to sell it for as much as you paid.

I go through this exercise for two reasons: one practical and one theoretical.

The theoretical reason is that this analysis reveals why I’ve been saying for the past several months that stocks are incredibly undervalued. Historically, the earnings yield of stocks isn’t anywhere near as far above the yield of bonds as it is today. Right now you get about a two-percentage-point advantage in stocks, compared to the norms of the last 20 years. There have only been a couple of brief moments when the advantage has been that great.

The practical reason is that you have a decision to make every single day: How do you invest your money? I’m not just talking about the new money you contribute to your investment accounts. I’m talking about money you have already invested. Every day you have to ask yourself what’s right, and ask yourself where the value is. As you think through the answers, the place to start is the most fundamental choice an investor makes: Do I buy stocks or do I buy bonds? After that, it’s all details.

If you get that big decision right, the rest will take care of itself. My point is that the numbers suggest a very substantial and unusual advantage right now to owning stocks rather than bonds. If you buy stocks instead of bonds, you get that advantage.

It’s not a guarantee. Nothing is. But whenever I make a decision I’m always looking for the advantage, and I generally follow that advantage. Right now the advantage is with stocks. Big time.

The following is an “Ahead of the Curve” column published June 17, 2005 on SmartMoney.com, where Luskin is a Contributing Editor.