valuation of stocks and bonds as it relates to privatizing SS scam

[Kurt_and_Hunter]

It seems to me that if the free market works, then in the long run the yield on bonds should be about the same as the expected yield of stocks.

A US treasury note is considered a VERY secure investment instrument. Say it pays 4% over ten years. If it were certain that a diversified portfolio of stocks would do better than 4% then nobody would buy bonds. Nobody.

The reason bonds only pay 4% (in this example) is that safety is factored into the price. The fact that stocks out-perform bonds in a given window of time is a matter of luck... the stock market happened to not collapse during that window. (Or collapsed and rebounded during that window.)

The point is that over 1,000 years stocks and bonds should make roughly the same amount unless the market is incapable of pricing bonds correctly--consistently over-estimating the risk of all other securities. (And if we concede that the bond market cannot price bonds correctly, what does it say about stock valuations!?)

So all claims that stocks intrinsically outperform bonds are utter bullshit. (I am not an economist, so if this is incorrect, please straighten it out.)

[ruggerson]

1. The reason people buy bonds

is because of safety concerns and the time factor. There is conclusive data that over long periods of time (over 7 years), stocks will out perform bonds by 2-3 percentage points.

If one had a thirty year investment time horizon, one would be better off putting $1000 into an S&P index fund than into treasuries.

[dugggy]

2. Over long term, stocks have returned better than bonds, gold,

commodities, and real-estate. My guess is what has been true for a couple of
hundred years is likely to hold up for another couple of hundred years.

[Kurt_and_Hunter]

6. Just my point... it is LIKELY to hold up

For purposes of securing the retirement of generations of people we are forced to consider things that are very unlikely. (Nobody in Germany in 1910 expected to lose two world wars within the next thirty-five years.)

I believe that bonds must factor in a disaster premium that distinguishes threats to national survival versus threats to corporate survival. It is easy to think of circumstances where the government survives in some form, but individual corporations go under.

(For one thing, corporations can declare bankruptcy, while the US government really can't)

I may be crazy, but projecting returns from history seems like the oldest economic suckers game. It's one of those things that works until it doesn't.

[dugggy]

11. Well...only the past is for sure...all future is conjecture

but you can't project future without looking at past results.

[Kurt_and_Hunter]

4. Is there a disaster premium that has never been cashed in?

I'm familiar with the relative performance data, but is that theoretical or empirical. (This is a rare instance where theoretical is better than empirical, for reasons I'll get to.)

Shouldn't bonds have a disaster premium built in to guard against possibilities that have never materialized? The safety factor that depresses bond yields is a real thing, but is it irrational?(it seems that bonds should have a liquidity advantage that increases, rather than decreases their value in terms of the time factor.)

My queery relates to the difference between securing an individual's retirement vesus securing the retirement of a genration. In the later case, the scale suggests that safety concerns take on a new dimension.

I know stocks have out-performed bonds in almost all time frames, but the American economy has grown in almost all time frames. (Almost all previous great civilizations have collapsed, so we are only looking at the first part of the American empire.)

America hasn't been hit by an asteroid since the founding of the NYSE. New York hasn't been nuked... half the population hasn't been felled by some new disease, etc. And that sort of ruin should be factored into security prices.

No matter how bad it gets, as long as the US government exists it can at least monetize its debt, paying at least something in deflated dollars. Any individual corporations can be wiped out with zero return under the same circumstances.

[Trillo]

3. It appears you have found a market inefficiency.

Ain't inefficiency grand?

What you have found appears consistent with the need to prevent information transparency for 'the game' to continue.

[A HERETIC I AM]

5. A couple of points:

It seems to me that if the free market works, then in the long run the yield on bonds should be about the same as the expected yield of stocks.

Why? I would hope you do realize that stock and bonds are not by any means the same type of security. Bonds are a loan you make to the issuer. Stock is part ownership of the issuer. What you are suggesting is that it should be just as profitable to loan money to a company as it is to own the company. This is rarely the case.

A US treasury note is considered a VERY secure investment instrument. Say it pays 4% over ten years. If it were certain that a diversified portfolio of stocks would do better than 4% then nobody would buy bonds. Nobody.

Wrong. Bonds pay interest. Stocks do not necessarily pay dividends, plus there is no requirement for a company that does pay a dividend to always do so. A portfolio that is 100% stocks can suffer dramatic declines in value just as it may experience dramatic gains. Bonds on the other hand pay that steady stream of interest until they mature, at which time you get the "par" value of the bond back (with few exceptions, bonds have a par value of $1000.00) While the market price of a bond may be bid up and down by the market during the time it is held, if you bought it at par, you are going to get your grand back if you hold it until it matures and you always know what that figure will be. If you can tell me what the price of a given stock will be in ten years, then you and i need to have a serious, sit-down talk! Yield on bonds is a function of the price paid vs. the "coupon rate". If you can buy a 5%, $1000 bond at a discount - say $900, your actual yield is higher than the 5% coupon rate because you get par back at maturity. The opposite is the case if you purchase the bond at a premium, $1100 for example. Bonds are held in a portfolio to provide income, stability and reduce overall volatility. Stocks have a much higher inherent risk than do bonds. In the case of a bankruptcy, bond holders are the first to be paid. Stockholders are the last.

The reason bonds only pay 4% (in this example) is that safety is factored into the price. The fact that stocks out-perform bonds in a given window of time is a matter of luck... the stock market happened to not collapse during that window. (Or collapsed and rebounded during that window.)

The reason bonds pay a given interest rate is based on market forces. Safety of principal being only one of them. Creditworthiness of the issuer is another. Maturity is another. Supply and demand still another. And the fact that stocks outperform bonds in a given window is not just "luck". It has to do with the perceived value the market gives to the company. If the company is seen to have a product the public marketplace wants or needs, has the potential for future profits and is well run, the market tends to bid up the share price. It is much too complex to just call it luck.

The point is that over 1,000 years stocks and bonds should make roughly the same amount unless the market is incapable of pricing bonds correctly--consistently over-estimating the risk of all other securities. (And if we concede that the bond market cannot price bonds correctly, what does it say about stock valuations!?)

So all claims that stocks intrinsically outperform bonds are utter bullshit.

Again, unless and until it is more profitable to loan money to a company as opposed to owning part of it, the claim is not intrinsically bullshit.

[Kurt_and_Hunter]

8. Thank you. Excellent post. A counter-point...

I am assuming that the matter of dividends, interest, gains, etc. is built in... make any assumptions about re-investment, par value, coupons, dividends, etc. and they still add up to a certain return within a time frame for a given security. That's what I'm comparing, head to head... the fully realized return, given the intricacies of each type of security.

It is automatic that owning a company is more profitable than lending to a company if the company survives the examined time frame. And if it pays a really fat dividend it could be profitable despite eventually going bust. But in the specific case of a company going bankrupt, lending is better than owning. And I don't know of any intrinsic bar to disaster in a long time frame.

My invocation of a 1,000 year horizon was because there is essentially zero chance that the US will be the world's largest economy for 1,000 years. And certainly we will not see consistent growth above inflation for 1,000 years. During that time frame several US cities will be leveled by nuclear weapons... no real way around it. The US will be hit with epidemics of diseases that do not exist today, And so forth.

My point is that for purposes of SS privatization the disaster factor is more pertinent than it seems in individual investment decisions. As an individual I can discard unlikely events because I'm only going to live so long. A national pension system must (or should) have a longer time frame and a lower risk tolerance than the sum of its individual clients.

It is a simple matter to imagine events that would render wide swathes of stocks worthless while the US government remained a going concern. (Outstanding loans would probably be paid in devalued currency, but it would be better than nothing.)

Since vast bond portfolios are held in the long-view global context of the rise and fall of nations, natural disasters, wars and such, I suspect that a millennium's worth of disasters would level stocks and bonds, and that the safety premium of bonds is not merely a psychological artifact, but an expression of real long-shot risks that stocks do not price properly for some reason.

But I'm a known crank.

[A HERETIC I AM]

9. Whew! wow. You lost me there but i think i found ya!

First, i want to say emphatically that i am against any plan to privatize Social Security. I don't want anything i might say to be construed otherwise. Social Security was never designed to be a complete pension. It was designed to provide a lifetime stream of income so that the elderly would not end up destitute with no income at all. In this regard, it has to be considered a resounding success. It needs work, to be sure and it needs protection but i think the last thing this Government program needs is to be turned over to the forces of the marketplace. It seems to me that the Government has realized it is not sufficient and that is why things like IRA's and 401(K) plans have been encouraged. It is in the individuals best interest to actively save for their retirement years so that those savings can supplement SS, but not necessarily do away with SS altogether. One of the problems with the current system is that people are retiring earlier and living longer. It is quite possible these days to find a person that has been retired almost as long as they were gainfully employed and contributing to the system. Figuring roughly age 20 as the starting point and roughly 65 or so as retirement age, 90 year old people are not nearly as rare as they once were. The ability of the system (and all the similar ones worldwide) to sustain itself with such an increasing and aging population has obviously been hotly debated.

I am assuming that the matter of dividends, interest, gains, etc. is built in... make any assumptions about re-investment, par value, coupons, dividends, etc. and they still add up to a certain return within a time frame for a given security. That's what I'm comparing, head to head... the fully realized return, given the intricacies of each type of security.

The problem i see with this statement is that you include "interest" in with "gains (&) dividends". They are 3 different things that, when one is talking about either long or short term performance, it's important to distinguish between them. Plus, they aren't "built in" and can not be assumed to be so. As I'm sure you have heard before, "past performance is no guarantee of future results". Again, not all stocks pay a dividend, there is no law or requirement that they do so, nor is there any law that says once they start to, they must continue. Some examples are Ford, GE and Microsoft. The first two have been around for about a century, the latter only a couple decades. After all these years on the NYSE, Ford motor company still does not pay a dividend to shareholders (and unless i am mistaken, they never have. If i am wrong, please correct me). GE has been paying one for years and Microsoft pays one also, but it didn't always. Also, the number of companies that issue stock and go public then subsequently fail makes a very long list indeed.

You state in your 2nd paragraph "And if it pays a really fat dividend it could be profitable despite eventually going bust". Well, only if those fat dividend payments added up to more than the initial price paid for the share of the now busted company. Another very rare thing. Companies with publicly held shares rarely start to pay dividends until they have established a history of being able to consistently make money and have succesive profitable years. Both the SEC and the NYSE have rules in this regard (I took and passed a test on this info but it escapes me at the moment!)

If i understand you correctly, i think you are on the right track vis-a-vis "the disaster factor" but you seem to question whether the market has it priced in. I think you might be surprised what the market prices in, and risk, both small and catastrophic are absolutely part of it. But traders do not consider on a daily basis that a Nuclear weapon might go off at the corner of Wall and Broadway nor should they. It is irrelevant. It becomes relevant when a clear threat appears, but for the most part, it isn't. As for the long term, the Social Security Trust Fund is, in my opinion only, best served by being invested in the United States Government, which it pretty much is. We just have to figure a way to make it self perpetuating at a 4 or 5% rate.

[Kurt_and_Hunter]

10. gotcha re: interest, dividends etc.

what I meant by head-to-head is that in a longish term investment model certain assumptions are made -- diversity of stock portfolio, mix of value and growth, dividends and how they're re-invested, bond interest and how it's reinvested.

The current SS bond portfolio is managed a certain way (badly, it seems) and the privatization pushers make certain assumptions about a different way to invest the money, and value after a certain period is compared apples to apples. So when someone says "historically stocks outperform bonds by X%" there's a set of assumptions made about the handling of both portfolios to end up with a dollar figure.

I know that stock market theorists flatter themselves over what's priced into the market, but it seems easy to falsify those claims since some (and sometimes a lot) of what is priced in is unquantifiable... GIGO. It's a circular argument.

It seems that if the market was as rational as Economics professors maintain say, it would be much more volatile. Those rational, fully-informed actors would buy and sell almost simultaneously. Since they don't, we know that much of what is priced in at any moment includes the sum of personal interests and psychological reactions that don't directly speak to the value of a company.

For instance, no sane person in June of 1999 thought internet stocks were worth even half of their price. The only rational reason to hold them (let alone buy them) was the "greater fool" theory. Whatever notion market traders had of the number and quality of fools was guesswork. I will grant that those hunches about the availability of fools were priced into the market with exquisite precision, but that doesn't mean the market is rational... just efficient. The average of a vast number of guesses is smoother, but not necessarily more accurate since human psychology is not random.

(Not to say there cannot be reasoned responses to a bubble environment... I have a theory that the best way to make money is to pile into any bubble in any country or asset class as soon as people start calling it a bubble, then bail after 1 year.)

Because bond people are more interested in capital preservation I suspect they are likelier to price long-shot disasters into the market than stock holders are... a hidden rational factor beyond mere timidity. That makes more sense to me than the idea that bonds are chronically cheap. So if there is a differential (emphasis on "if") it seems that the more speculative market would be the one likelier to under-price risk.

[Turbineguy]

7. Stocks perform as a market

and do not necessarily reflect the overall economy. But stocks perform as money flows into (or out of) the markets and chases shares of stocks. Bonds vis-a-vis stocks perform based on comparative risk.

One of the reasons (and possibly the main reason) the stock market has performed as well as it has recently, is government borrowing to offset tax cuts and fund a war, much of which ends up in the stock (and bonds) market. So while wealth continues to be created, the overall value of the stock market is helped by this influx of money. The real and total value is merely the net wealth created (which may actually be negative). This is reflected to a degree in the drop in value of US currency against others (but the currency behaves as a market as well and therefore may not reflect true value).

However, because of comparative risk, stocks will under perform bonds if liquidity is not poured into the stock market.

The problem is that while everybody will eventually have to cough up their fair share to pay off government borrowing, there are those who own stocks and bonds who will recoup and those who do not who will get less than nothing. Part of the population own debts and assets, the other part own debt. Those who own debts and assets win, the others lose. In a normal poker game players go broke and leave, are replaced, those who end up owning the pot stay longest. In this poker game, additional money is magically added to the pot, paid for by people walking past the casino who do not partake in the game and therefore have no chance of winning.

Obviously more mature (in terms of experience) investors tend toward lower risk investments and therefore under ideal circumstances would end up purely owning bonds having made risky money earlier. In other words, a new investor buys a risky stock, makes say, 5 times his original investment, matures and converts to bonds and considers himself to be earning 20% on his original investment instead of 4%.

Therfore your assertion that stocks intrinsically outperform bonds is utter BS is correct.

(But I'm not an economist either, merely live across the street from one.)

I hope that's clear.