Cana­dian bonds vs. stocks: Which is the bet­ter pick for long-term re­turns?

The Globe and Mail (Alberta Edition) - - REPORT ON BUSINESS - NOR­MAN ROTHERY PhD, CFA, is the founder of St­ingyIn­

Hick­ory, dick­ory, dock, In­vestors moved into stocks; The trend turned down, They ran into bonds, Hick­ory, dick­ory, dock.

In­vestors who scurry like fright­ened mice from stocks to bonds, and back again, rarely suc­ceed. But dis­ci­plined trend-fol­low­ers might be able to have the cheese of­fered by bull mar­kets and eat it while avoid­ing down­turns. The his­tor­i­cal record con­tains a feast of pos­si­bil­i­ties for trend-fol­low­ers. But I’ll fo­cus on Cana­dian stocks and Cana­dian bonds to­day.

They’re rep­re­sented by the to­tal re­turns of S&P/TSX Com­pos­ite In­dex and the FTSE TMX Canada Uni­verse Bond In­dex.

The Cana­dian mar­ket served up a big sur­prise over the years. Be warned – if you’re a stock in­vestor, it might give you the hee­bie-jee­bies.

Sim­ply put, Cana­dian bonds out­paced Cana­dian stocks over long pe­ri­ods.

The Cana­dian bond in­dex ad­vanced at an aver­age an­nual rate of 8.6 per cent from the end of 1980 to the end of Septem­ber, 2018, while the stock in­dex climbed by 8.3 per cent an­nu­ally.

Stock in­vestors took a huge amount of risk over the nearly 40-year pe­riod.

They ex­pe­ri­enced six big bear mar­kets along the way, only to wind up do­ing worse than bond in­vestors. Life hardly seems fair – but in­vestors learned as much from child­hood fairy tales and fables.

Mind you, the pe­riod cov­ers a gi­ant bull mar­ket for bonds. It started when in­ter­est rates were sky-high in the early 1980s and ended af­ter rates slid down the mar­ket’s beanstalk to un­ex­pected lows in re­cent years. Bond in­vestors now face less than promis­ing prospects. The iShares Core Cana­dian Uni­verse Bond In­dex ex­change­traded fund (XBB), which fol­lows the bond in­dex, had an aver­age yield to ma­tu­rity of 3 per cent at the end of Septem­ber.

The yield rep­re­sents a guess at the in­dex’s likely aver­age re­turn over the next sev­eral years. In other words, bonds are un­likely to gen­er­ate 8-per-cent an­nual re­turns. The ex­tra­or­di­nary record is just the start of the tale. Now imag­ine a trend-fol­lower who put all of their money into ei­ther the stock or the bond in­dex each month.

They moved into stocks when stocks out­paced bonds over the prior 12 months. They ran into bonds when stocks un­der­per­formed. For in­stance, at the end of Septem­ber, the bond in­dex had climbed 1.7 per cent over the prior 12 months and the stock in­dex was up 5.9 per cent.

As a re­sult, they would have put ev­ery­thing into Cana­dian stocks for Oc­to­ber. (The iShares Core S&P/TSX Capped Com- posite In­dex ETF (XIC) is a good way to in­vest in the stock in­dex.)

The trend-fol­low­ing method as de­scribed gen­er­ated aver­age an­nual re­turns of 10.7 per cent from the end of 1980 to the end of Septem­ber, 2018. It beat the bond in­dex by an aver­age of 2.1 per­cent­age points an­nu­ally and the stock in­dex by 2.4 per­cent­age points an­nu­ally. (All of the re­turns herein in­clude rein­vested div­i­dends, but they do not in­clude fund fees, com­mis­sions, taxes or other trad­ing fric­tions.)

The re­turn boost from trend-fol­low­ing might look as ap­peal­ing as a shiny red ap­ple. Not to worry, I don’ t think it’ s poi­soned, but it might be a lit­tle wormy.

Prob­lem is, with the six big bear mar­kets in Canada over the pe­riod, it turns out the trend fol­lower jumped out of stocks 21 times. Much like mice run­ning up and down the clock, they were over­ac­tive – and fre­quently wrong. While tim­ing saved them when it re­ally mat­tered be­fore big down­turns, it also served them poorly in choppy bull mar­kets when they lagged.

If you’ re like me and areas ac­tive a trader as a lazy cat is a mouser, you’ll be con­tent to watch the mar­kets scurry to and fro.

But those who are more ac­tive should perk up be­cause Cana­dian stocks have un­der­per­formed over the past 12 months. If the cur­rent down­turn be­comes more se­ri­ous, they’ ll be sit­ting safely on the side lines. On the other hand, the bear mar­ket may prove to be lit­tle more than a fairy tale – this time around. Only time will tell. Hick­ory, dick­ory, dock.

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