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Friday, July 5, 2013 - 08:30

Trade Less, Earn More? This System May Point The Way

Friday, July 05, 2013 8:30 AM

Income-starved investors are faced with bleak prospects. Stocks in the S&P 500 index might only reward investors with a dividend yield of 2% or so over the next 12 months. As an alternative, investors could consider 10-year Treasury notes, but those pay even less.

Based on history and very long-term charts, stocks do seem like the better choice.

Prior to 1951, stocks offered investors more income than bonds. As you can see in the chart below, something changed in 1951, and bond yields topped dividend yields for the next 60 years. In November 2011, the relationship reverted back to its historical alignment, and stock market yields have been at least slightly above bond yields ever since.

This relationship is important to income investors because asset allocation rules have been developed based on the data. Many retirement investors have learned that a balanced portfolio should be 60% invested in stocks and 40% invested in bonds.

Other retirement plans are based on the idea that stocks should be held in a percentage equal to 100 minus your age, with the rest in bonds. For a 70-year-old, that would mean a 30% allocation to stocks and 70% to bonds.

These rules were developed based on interest rates that were highly volatile by historical standards.

No one knows why bond yields topped dividends in 1951, but that was a time of transition for the global economy. With the end of the war came massive rebuilding efforts, and the spending on those projects restored growth.

Although growth would remain uneven, investors realized that the prospects for stocks were better than they had been in the past. Wars had been frequent throughout history, but the rebuilding of broken economies by the war's winners was different. Unlike the end of World War I, which brought financial hardship to the losing nations, World War II ended with hope for the future.

This new environment seemed to result in a lower risk premium -- the additional income that investors demand for an asset that presents a greater chance of loss -- for stocks, which would be seen in the low dividend yield relative to bonds. Inflation seemed to be more likely than industrial collapse as the world's economy grew, and inflation made bonds riskier relative to stocks of the companies that would rebuild nations.

Financial planning rules about bonds were drafted when interest rates were more volatile than ever. Looking at the long-term chart above, interest rates were in a basing pattern for about 80 years until the 1930s. The next 60 years would include new all-time highs and then a return to the levels seen in that long base. The challenge now is to understand whether rates are returning to a time of low volatility or entering another period of instability.

Many charts display some degree of symmetry, which is the reason traders look at chart patterns. They expect down moves to be about the same size as up moves, which leads to measurable price objectives for patterns like a head-and-shoulders top.

There was a symmetrical rise and fall in bonds over the six decades beginning in 2011. Although inflation and an interest rate spike are possible, it is also possible that rates will remain low and steady for years as they did on several occasions between 1871 and 1951.

In almost any scenario, bonds seem unattractive relative to stocks:

-- If interest rates remain low, bonds could be a bad investment because they offer little income.

-- If interest rates move up sharply, bonds would be a bad investment because they would suffer large losses of principal (bond prices fall when interest rates rise).

-- If interest rates fall from here, the upside from principal appreciation is limited because rates are so low.

There are reasons to hold bonds besides income. Bonds are less volatile than stocks and could preserve capital if stocks sell off. But those relying on old rules should look at the long-term chart to see that we could be in a much different investing environment than what investors faced in the past.

Action to Take --> Use current data and make decisions about your income. Consider stocks as income investments. Many of the largest stocks are offering yields higher than the interest available from long-term bonds in the same company. The stocks offer potential appreciation plus income that could increase in time. Bonds offer only a return of capital and steady income if held to maturity. In this environment, stocks beat bonds for income.

This article originally appeared on ProfitableTrading.com:
This Once-Safe Investment May Be The Worst Place to Have Your Money Now

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.