Hi Mike, I discovered your blog very recently. It is a pleasure to read your blog in terms of clarity. I would like your opinion on the current "average" interest rates afforded by the market to savers and investors a measly 2-3%. This number translates to a p/e of 50 - 30 equivalent. A portfolio of 50/50 stock/bond therefore, will have significantly high p/e since safe bond portion of the portfolio is now at somewhat a "zenith" p/e ratio. As I understand predictions of either stock or bond market "p/e" are unwise how does one diversify ones bond portfolio?
Thanks for writing and for the kind words about my blog. I have a much lower opinion of my writing's quality, but am certainly glad that the points I am trying to make come across anyway. As to your question... I strongly believe it's a bad idea to think of inverse of bond yield as bond's "price-to-earnings" (P/E) ratio because it can quickly lead you down the completely wrong road in estimating and appreciating the price stability of bonds.
When the broad stock market is trading at such high price-to-earnings ratio it is quite likely in a bubble and can easily lose half its value or even more when that bubble pops. This risk is very real and has already manifested itself twice in the past 15 years and countless other times in history. Sometimes these crashes may come when P/Es are not even particularly high at all because of some external economic or geopolitical event. Stocks by their nature will always be subject to this sort of roller coaster ride. The only reason we invest in them is because with such risk come expectations of higher returns as well. But these expected high returns are under no obligation to materialize soon or, indeed, at all. Historically things have played out quite favorably for stocks with recoveries from most crashes taking just a few years but the future may not be so kind. Bottom line, stocks are always risky and times when stocks have high P/Es are riskier still. (I'm ignoring for the purposes of this discussion the 2008-9 scenario when broad market price-to-earnings ratio was extremely high due to huge but one-time write-offs in the financials -- in reality most stocks still had positive, though depressed earnings while financials had huge negative earnings and adding them all up resulted in a small positive number, giving a misleading picture of sky-high broad market P/E.)
The same is simply not true of majority of bonds. Cash, which is best thought of a zero-maturity bond, will never fluctuate in price at all, even though its current "P/E" is somewhere between 100 and infinity. A dollar is always worth a dollar, regardless of whether it yields 0% or 10%. Short-term bonds (under 3 years maturity) may swing in price maybe 5-10% in an extreme move. Intermediate-term bonds with maturity of, say 3-10 years (these labels -- short, intermediate, long -- are far from being a tied to a specific number) could be expected to fluctuate by maybe 10-15% at the most. In reality most of the price moves are far smaller. Here is a chart of nearly 20-years worth of price movement alone (ignoring interest) of Vanguard's short-term (blue line) and intermediate-term bond funds (orange):
(The total bond market invests in all maturities of bonds which average out to intermediate-term maturity). As you can tell, the current price of the total bond market is about 10% higher than before the crisis. A return to normal interest rates would see that reversed, with a loss of maybe about 10% (this is a rough guesstimate, of course). The real-life loss will be even smaller because you will continue to receive interest during the drop in price. While nobody wants to lose 10% it is simply not any kind of disaster. Virtually anybody can adjust to a 10% loss in a portfolio with some inconveniences, but nothing dramatic like standing in soup lines. And this is all assuming we return to normal interest rates quickly, which is a huge assumption in itself.
Only when we start looking at long-term bonds, especially at their 30-year extreme do we start to see at least the potential for price drops that resemble what happens to stocks fairly regularly. And even then long-term bonds never approached 50% drops, not even when we went from the ultra-low interest rates of 1950s (which were even lower than today's at the long end of the yield curve) to the ultra-high interest rates and inflation of 1970s. At worst the nominal price drops were on the order of 20-30% over a couple of years (exacerbated by high inflation, but ameliorated by interest payments).
Bottom line, bonds are simply much much less prone to price swings than stocks. That's why thinking of bonds as having a high price-to-earnings ratio is misleading. The reason we are afraid of high price-to-earnings in the stock market is because it signifies a bubble that is likely to pop bringing with it huge losses. But a bubble in the bond market simply will not pop like that. It is much likely to be a slow deflation than a horrifying pop. You may also find a post I made about a year ago concerning the "bond bubble" interesting: http://www.longtermreturns.com/2012/03/great-treasuries-bubble-in-perspective.html
What's not subject to debate is the fact that today's low yields on bonds will result in mediocre returns going forward, at least out to today's bonds' maturity. Unfortunately there isn't a whole lot we can or should do about that, besides slightly improving our portfolios by tossing out the relative "duds" (treasuries, TIPS) in favor of the relative "deals" (I-Bonds, CDs, EE-Bonds). I've been focusing on writing about these options for the last few months, if you are interested in flipping back a few e-pages.
As is hopefully clear from the above, you should not be considering exchanging all your doomed-to-mediocrity bonds for potentially-high-returns stocks because of the downside of stock investing. If stocks were obvious bargains with low cyclically-adjusted P/E (lower than historical 16-18) and high dividend yields (higher than historical 4%), then there might be a good argument for going heavy on stocks. Unfortunately, today's stocks are not particularly bargain-priced. They are somewhere between fairly- and over-valued. Which, of course, doesn't mean you have to sell them all, but it does mean that now is not the time to pile into them. The time to pile into risky asset classes is after they have undergone huge bear markets. For stocks that time was four years ago -- and they have about doubled in price since.
It is best to not think of stocks and bonds as being interchangeable for one another. Their behavior is drastically different. Both are very worthwhile investments, but for different reasons. Stocks bring a chance of high returns. Bonds bring some return too but more importantly they bring much better price stability, which is always important for psychological reasons but is multiplied in importance near and during retirement for financial reasons. If all you invest in are stocks and you are forced to sell them to finance living expenses during a bear market you will be subject to a very real risk of running out of money early as you "lock in the losses". Continue to invest in both stocks and bonds, lower your expectations for future returns from both, and hope to be pleasantly surprised.