Are Stocks and Bonds Really Different?

In the long-term, investors in stocks and bonds have different goals but the performance of the two investments has been about the same over the past thirty years. Given the similarity in long-term performance, it is worth looking at the question of whether or not stocks can be traded with the same strategies as bonds or other futures contracts. After testing, we can conclude that they trade differently over the short-term and we can also conclude that a diversified basket of futures is better for small traders than either stocks or bonds.

Most experts have produced results that show stocks outperform bonds in the long run. Typical of their proof is an example like, “One dollar invested in stocks in 1802 would have grown to $8.8 million in 2003, in bonds to $16,064, in treasury bills to $4,575, and in gold to $19.75. The CPI has risen by a factor of 14.22.” This is from Jeremy Siegel, author of the book “Stocks for the Long Run.” Traders don’t have a two hundred year investment horizon and studies like this invariably use time frames that would span several lifetimes.

A typical investor often has thirty years to create wealth. In early November 2011, the investment community was shocked to learn that bonds had outgained stocks over the previous thirty years. Jim Bianco, president of Bianco Research, released a study that showed long-term government bonds had gained 11.5 percent a year on average over the thirty years ending October 31, 2011, compared to a 10.8 percent annual gain in the S&P 500,

Siegel was quick to defend stocks and was immediately quoted on Bloomberg as saying “The rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward whereas stock returns can repeat themselves, and are likely to outperform. If you missed the rally in bonds, well, then that’s it.”

Siegel also observed that the last time bonds outperformed over a thirty year period was in 1861, when the US was moving from an agricultural to an industrial economy.

The last thirty years saw a shift from an industrial to a services economy, and in time that may be seen as explanation for how investments performed recently. All of this data is interesting, but the point is that stocks and bonds seem to have similar return characteristics in the long run. If that holds over the short-term, trading systems that work on bonds should fare well on stocks.

Bonds are traded as futures, and that offers traders a high degree of leverage. Stocks do not offer the same benefit and a much larger account size is required to trade individual stocks when compared to trading futures.

A successful futures strategy is the four-week rule, which is always in the market either long or short. Traders buy when the price reaches a new four week high and reverse to go short when the price breaks down to a new four week low. We’ll test the idea using 20 days in addition to four weeks, on both bonds and stocks.

Applying this strategy to the ten-year bond futures contract, a trader would realize returns of 11.92 percent a year over the past twelve years. That return assumes the trader starts with a $1,500 account which is just a little more than the exchange minimum margin on that contract. With an account of this size, it isn’t possible to test trading systems on a diversified basket of stocks. Since there is no way to know in advance which stock will be a winner, testing should include a diversified list of stocks. To obtain comparable benefits of diversification, we will test a diversified basket of futures and compare that to stocks.

Before testing the diversified portfolios, let’s look at results on the S&P 500 index. The big contract requires a margin of more than $30,000 but the e-mini can be traded with a margin of about $6,000. The four-week rule would offer returns that are only about half those of bonds, 6.44 percent a year on the e-mini. Risk is slightly higher for the e-mini than for the bonds.

The diversified futures basket that was tested included crude oil, cotton, the US dollar index, feeder cattle, five-year Treasuries, copper and sugar. Test results are from January 1, 2000 through the end of November 2011. A starting account balance of $30,000 was used so that we can apply the same methodology later to the 30 stocks in the Dow Jones Industrial Average. Commissions and slippage of $45 per round turn were deducted from each trade.

Using daily data, the system delivered an annual return of 19.85 percent. Only 40.3 percent of trades were winners and the maximum draw down was about 33 percent of the total profits. Turning to weekly data, the annual return increases to 21.31 percent, the percentage of winning trades is slightly higher at 42.2 percent and the worst draw down is only 23 percent of the profits.

Turning to stocks, we will test the idea using the components of the Dow and deduct $25 per trade for slippage and commissions. This may seem high given low commission rates but includes slippage which can be significant in a fast moving market. A $30,000 initial account balance will be used so that the initial position size in each stock will be $1,000.

On daily data, the results are disastrous with losses totaling almost $150,000. On weekly data, losses total more than $30,000 during the test period. Both time frames would result in losses even if we assumed trading was possible without any costs for slippage and commissions.

Sometimes a bad trading system idea can be transformed to a profitable one by flipping the rules. That doesn’t happen in this case. Daily and weekly data continue to be long-term losers when new lows are bought and new highs are sold. Both longs and shorts fail to deliver gains.

Similar results are obtained with tests on a long-term moving average crossover strategy. These tests use moving averages of 50-days and 200-days and are always long or short – long when the 50-day is above the 200-day and short when the opposite condition applies. The futures basket is profitable with low draw downs and the basket of stocks is unprofitable.

Using a single moving average system performed the same way and showed profits in futures with losses in stocks. This system was long if the price was above the 20-day moving average and short when the price closed below the average. For those considering this idea, the four-week rule worked much better on futures and would be a better trading strategy to employ.

These results allow us to draw several conclusions that are important to traders.

In the long-term, stocks can deliver inflation-beating gains and bonds can provide extended periods of outperformance. On a fundamental basis, Siegel is correct that bonds can not deliver double digit gains over the next thirty years because the current yields are so low. Bonds rise in value when interest rates fall and in the past thirty years rates fell from more than 15 percent to less than 2 percent. With the ten-year bond yielding only about 2 percent, the gains in that bond are capped. Rates can only fall to 0, which is unlikely for the long bond. Japan enjoys low inflation and expectations of future inflation are low. The ten-year in Japan yields 0.98 percent. If the US ten-year fell to that level, bond prices would appreciate in value from the current price, but much less than in the past. Low price gains and low interest rates almost guarantee bonds will underperform over the next thirty years.

Risks are greatest when a single position is held in a portfolio and no trader should limit themselves to one market. That is sometimes necessary for small traders who are just starting but they need to add different trading vehicles as their account grows.

Stocks and bonds really are different in the short-term and neither is the best choice for small investors. Small traders can not actually trade individual stocks because they do not have enough capital in their accounts. That makes the best choice for small investors futures, or forex for the smallest investors. Using the simple four-week rule can deliver steady profits and allow an account to grow, meeting the real goal of investors.

By Michael J. Carr, CMT

Trading involves substantial risk of loss and is not suitable for all individuals. Past Performance is not indicative of future results.