Whenever there is high volatility in the stock market, people talk about the “flight to
safety.” Since every financial asset has both a seller and a buyer, this whole idea is
debatable—for every investor buying the perceived safe havens of gold, government bonds
and US dollars, someone else is selling them. What isn’t debatable, however, is that during
the last few weeks these safe havens have all performed well, while other “risky assets” like
high-yield bonds, stocks and REITs have not.
The larger question is whether it makes sense to trade risky assets that have recently gone
down in price for safe havens that have held steady or even gone up. Put another way, is it
worth trading potential growth tomorrow for lower volatility today?
Remember, this is a decision you need to consider based on the future, not the past. Of
course, the results would have been outstanding if you had sold your risky investments
in early April and shifted your money into safer ones. Unfortunately, you can’t magically
travel back in time and profit from events that have already transpired.
Going forward, then, what is the best strategy for investors?
In my opinion, “safety” comes at a high price in the form of very low expected returns in
some of these assets. In fact, some of the traditional safe havens may not provide any safety
at all. I invite you to consider the following points and make your own judgment:
- 1-month Canadian T-bills are yielding less than 1%
- 90-day US T-bills are yielding 0% (actually 0.01%)
- The best interest rate you can get on CDIC-insured savings accounts is 1.5% to 2%. With inflation at 2.7% over the last 12 months, money in these “risk-free” accounts
is losing purchasing power every day.
- The yields on Canadian government bonds are at or near historic lows. As of August 18, the yield on 5-year bonds was 1.4%, while 10-year bonds were yielding 2.3% and 30-year bonds 2.96%. (Source: TD Waterhouse)
- With bonds, the yield-to-maturity equals the expected return if you hold the bond to maturity. That means if someone were to buy a 10-year government bond today and hold it to maturity, they would earn 2.3% per year. Similar to cash, this “safe haven” bond is losing purchasing power every day, even before we consider the almost 50% tax rate on bond interest income.
- If long-term interest rates were to rise by one percentage point, then the price of the 30-year bond would go down by over 20%, erasing almost seven years of interest payments
- Gold has more than quadrupled in price since the beginning of 2005 (in US dollars), and is up more than 40% since last October, when Warren Buffett made the following comment: “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all—not some, all—of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
- The dividend yield of Canadian stocks (as measured by the S&P/TSX Composite Index) is now 2.8%. This is almost equal to the yield on 30-year Canadian government bonds—and dividends are taxed at roughly half the rate of bond interest income. More important, comparing yield alone ignores the growth potential of the Canadian stock market over the next 30 years.
- Global stock markets are now trading 20% to 40% below historical averages measured by ratios like price/earnings, price/dividends and price/book value.
As we all know, short-term moves in financial markets are entirely unpredictable. So bond yields could go even lower, the price of gold could climb higher and, of course, stock prices could continue their slide. But if you are a long-term investor, the key question is: how likely is this over any reasonable time horizon?
As John Bogle, the founder of Vanguard, said so eloquently about investor behaviour: “Time is your friend, impulse is your enemy.”