Stocks or Bonds?

FIRST-HAND experience in the investment market during the past eight or nine years should have familiarized every bond buyer with the causal relationship existing between interest rates and the general level of bond prices. In 1921, for example, bond prices were extremely low. They were low because interest rates were high. In the years immediately following, new life was put into the bond market by the redundancy of credit and cheap money. Bond prices rose, and they continued to rise with only slight interruptions until the early part of 1928. Since that time the general trend has been downward in response to a grow - ing shortage of credit and higher interest rates.

Thus the nine-year cycle presents a complete picture of the rise and fall of bond prices resulting from the fall and rise in interest rates.

There was a time when movements in the prices of investment stocks were governed by changes in money rates in much the same way — except that bond prices, being more sensitive to money market conditions, moved up or down a few weeks or months in advance of stock prices. As a rule, bonds led the way and investment stocks followed.

If good 5 per cent stocks and bonds were worth, say, 100 when the rate of interest was a per cent, it could safely be predicted I hat a decline in the rate of interest to 4 per cent would raise their price well above 100. An investor who paid as much as 125 for a 5 per cent stock could still get a return of 4 per cent on his investment. Compared with bonds, investment stocks usually gave a higher yield, because’, from the point of view of safety of principal and dependability of income, they were regarded as inferior investments.

The situation as betw een stocks and 38 bonds is vastly different nowadays from what it used to be. In the first place, the prices of investment docks do not seem to respond so readily to changes in interest rates. While bond prices have been responding in a perfectly normal manner over the past eighteen months, falling as the result of rising interest rates, stock prices have been transgressing all the rules of the market. They rose almost steadily through 1928 notwithstanding the rise in interest rates, and they continued to rise during the early months of the current year. The sustained upward movement of stock prices in the face of such conditions is without precedent.

Another point of difference to be noted is that the traditional relationship between bond yields and stock yields has been reversed. Instead of yielding a higher average return than bonds, Comparable investment stocks now yield less — in some instances a good deal less. It is not unusual to find investment stocks selling to yield anyw here from 2 to 5 per cent, while first-class bonds offering the investor a return of 5½ per cent are available in any quantity. The most casual observer of the trend of affairs in the security markets cannot fail to note that the ideas of investors as to the relative value of stocks and bonds have undergone a far-reaching change during the past few years.

What is the reason for this change?

One of the outstanding reasons is the growing conviction in the minds of investors that a diversified group of common stocks will give a better return over a long-term period than an equal investment in bonds. It can be shown empirically that during a period of rising commodity prices the holder of good .common stocks is in a better income position than a bondholder. The rate of return on a bond is fixed by contract., whereas there is always the possibility, amounting almost to probability, that the dividend return on a diversified group of stocks will increase as commodity prices rise. Numerous investigations have established the fact that over the past thirty years bondholders have lost, gradually but surely, a large part of their interest income and a part of their principal besides, on account of the decline in the purchasing power of the dollar, — that is. through the rise in commodity prices. while the holders of good common stocks have received a dividend income and an appreciation in principal which more than offset all losses due to a depreciating currency.

The investigators also find that during a period of falling prices common stocks just about hold their own with bonds as producers of income, and actually forge ahead of bonds when the level of commodity prices becomes stationary. The conclusion seems to be that common stocks alone constitute the ideal form of investment security.

There is much to be said in favor of common stocks as long-term investments. The modern world is one of almost continuous growth, retarded at times, to be sure, but nevertheless certain over the long period. Furthermore, sound corporate policy requires that only a portion of earnings be paid out in dividends, and that surplus earnings over and above dividend requirements be reinvested for the future benefit of shareholders. It is in this way that many American corporations have risen to their eminence, and it is still regarded as the American way. The record of corporate growth on the basis of reinvested earnings has contributed no small share to the prevailing sentiment: ’You can’t go broke betting on the United States.'

For obvious reasons conservative investors have been forced to revise their attitude toward common stocks. But does it follow that such stocks are to be given preference at any price; that the present spread between bond and stock prices is justified; or that there is not still a place in most investment holdings that should always be reserved for bonds?

Current expressions of faith in the superior qualities of common stocks generally overlook the fact that most investment lists require something besides power of growth or income-producing capacity. There are few investors who at some time or other are not confronted with the necessity of selling securities in order to raise cash. And how often must the holder of stocks sell at a loss! Common stocks have a way of falling precipitously at times. Over the past thirty years there have been periods of more than a decade in length during which the holder of good marketable stocks would have had to take heavy losses if he had been called upon to convert his holdings or any portion of them into cash. It is true, of course, that bonds also fall in price, but their market fluctuation is much less than that of common stocks. Owing to their greater steadiness in value and the assured income they afford in emergencies, bonds still deserve to be given a prominent place in the holdings of the average investor. They are a first and last line of defense in time of stress.

Another point which is overlooked by those who laud the virtues of common stocks is that any investment formula purporting to be good for all time or for all classes of investors is certain to mislead the unwary. There are times when one should buy bonds rather than stocks. There are fashions in the security market no less than in the commodity market fashions which linger and then pass away. Just as good bonds have been neglected in the investment market of late, so the time will come whan investment stocks will be neglected in much the same way.

The fact is not sufficiently recognized that the present high market for investment stocks is the result fundamentally of credit inflation growing out of our world-creditor position, aided and abetted by a marked tendency on the part of the new school of security buyers to overemphasize some of the newly discovered virtues of common stocks. The buyers of these stocks no longer give serious consideration to high interest rates or low dividend yields. They are inclined rather to value stocks in terms of present and prospective earnings which may never become available for dividends. In times of rampant credit inflation like the present, a great deal could be said for a policy of buying conservatively priced bonds, reserving for a future period of credit contraction the purchase of those investment stocks which are now priced out of all proportion to their dividend return.