When to sell stocks and buy bonds (according to Peter Lynch)

Risk-free government Treasury yields have risen sharply over the past year.

The increase is a direct result of the Federal Reserve rate hikes that began in 2022.

Higher short-term returns are good for retirees and give us multiple options to earn risk-free returns on idle cash while maintaining liquidity.

But the rapid pace of rising federal funds rates has had unintended consequences, as we saw last week with the failure of Silicon Valley Bank.

We’ve gotten so used to lousy government bond rates over the past decade that the latest yield curve has excited income investors, even as inflation remains higher.

Here’s a look at today’s yield curve compared to a year ago.

Investors believe that higher rates are a short-term phenomenon to deal with inflation, which inverts the yield curve.

This is when short-term rates are higher than long-term rates, especially when the 2-year rate is higher than the 10-year rate.

An inverted yield curve is indicative of a possible upcoming recession.

But the 2-10 gap has narrowed in the past week on anticipation that the Federal Reserve could pause or slow the pace of future rate hikes due to regional banking volatility.

A “normal” yield curve is indicative of a healthy growing economy. It slopes from left to right, as shown by the red line.

Short-Term Treasury Yields Now Outperform Most High Yields savings accounts and dividend ETFs, making them an attractive income investment.

Owning Treasuries can be as easy as setting up a central position “sweep” with your brokerage account, where any idle cash is transferred to an interest-bearing account.

Investors can also buy individual bonds or specific term bond funds or ETFs to gain exposure and receive the return.

Some investors may even question whether the time is right to sell stocks to buy government bonds in light of the higher rate environment and market volatility.

For long-term investors, the answer is no.

As a general rule, stocks outperform bonds, by far. This is especially true as the investment horizon lengthens.

So trying to time the market by getting out of stocks and buying government bonds is a bad idea.

Here’s a chart showing the long-term returns of stocks vs. short-term and long-term bonds since the start of 1928:

Between 1928 and the end of 2022, stocks outperformed the 10-year Treasury note by 89 times.

A $100 investment in the S&P 500 in early 1928 would have been worth $624,534.55 by the end of 2022, including dividends.

The same $100 investment over the same period in 10-year T-bills would be worth $7,006.75, and 3-month short-term Treasury Bills would be worth $2,140.51.

Therefore, for most of us with a long-term perspective (more than five years), it only makes sense to sell stocks to buy bonds by adjusting the stock-to-bond ratio of your portfolio or during annual portfolio rebalancing ( more information on the relationship between stocks and bonds). in the end *).

Peter Lynch highlights an exception to the stocks outperform bonds rule in his 1993 book, hitting the street.

When to sell stocks and buy bonds (according to Peter Lynch)

Peter Lynch is the legendary mutual fund manager who ran Fidelity’s Magellan fund from 1977 to 1990. The fund averaged a 29.2% annual return during his tenure, outperforming the S&P 500 by more than double.

His books were among the first I read when I started investing in the mid-1990s.

Lynch received his undergraduate degree from Boston College, where a friend of mine was studying finance and recommended his books. One up on Wall Street and hitting the street.

I remembered a passage in one of the books about when to sell stocks and buy bonds and located a copy to refresh my memory.

Lynch spends most of hitting the street encourage investors to own stocks instead of bonds.

He used a similar comparison between stocks and bonds as in the chart above. Their comparison was from the 1920s to around 1990.

Fountain: hitting the street

Peter’s Principle #2:

Over the full 64 years covered in the table, a $100,000 investment in long-term government bonds would now be worth $1.6 million, while the same amount invested in the S&P 500 would be worth $25.5 million. Gentlemen who prefer bonds don’t know what they’re missing.

It is consistent with his preference for stocks over bonds, with one exception.

Peter’s Principle #8: The only exception to the general rule that owning stocks is better than owning bonds:

When long-term government bond yields exceed the S&P 500 dividend yield by 6 percent or more, sell your stocks and buy bonds.

Add context:

Interest rates had risen so high that my largest fund position for several months in a row was long-term Treasuries. Uncle Sam was paying 13 to 14 percent for these. I didn’t buy bonds for defensive purposes because I was afraid of stocks, as many investors do. I bought them because the returns exceeded the returns one might normally expect to earn from stocks.

Interest rates in the early 1980s skyrocketed when Paul Volker raised the federal funds rate to quell inflation. Although the economy suffered in the short term, Volker is considered a hero for making the difficult decision to trigger a recession to end the inflation of the 1970s for good.

Lynch assumed super-high rates wouldn’t last long and bought long-term US bonds. It is not clear if he was kept to maturity or not.

The 1980s were an anomaly in the last 80 years. Rates peaked in 1980-1981. Then, from the early 1980s to 2022, government bond rates trended downward.

Fountain: longtermtrends.net

Looking at today’s rates compared to the past 80 years, it appears that we are in the early stages of reversing the 40-year downward trend. But we are still far from a point where it makes sense to sell stocks to buy bonds.

The S&P 500 is yielding just under 2% and the 10-year T-Bond is yielding 3.7%.

so according to Peter’s Principle #8we are still 4.3 percentage points away from when we would start considering selling stocks to buy bonds.

Your principle makes sense because if long-term stock market returns average 9% per year with significant market risk, wouldn’t you accept a risk-free return of 8%?

But even so, we are not mutual fund managers. Such high rates can be an opportunity to put new investment dollars into risk-free long-term bonds, but I’d be hesitant to sell stocks for that purpose considering multiple factors like capital gains taxes, quitting winners, and overthinking.

Here is the yield curve for August 21, 1981, compared to today:

We’re nowhere near the inflation or interest rate levels of the 1980s, but higher rates are putting banks in a loop. That’s because everyone has gotten used to low rates.

Once inflation begins to normalize closer to 2%, the Federal Reserve may lower rates again. But at this stage, we don’t know how much rates will need to rise to quell inflation or if going any higher will expose other naked swimmers.

Will rates go as high as they were in the 1980s? Let’s hope not.

And when rates go back down, who knows how far?

Hold on to that pre-2022 mortgage.

* Determine your stock to bond portfolio ratio

This is a general rule of thumb for determining your portfolio’s ratio of stocks to bonds.

120 minus your age = % stocks in your portfolio.

If you have a higher risk tolerance, use 130. Lower, use 110.

For example, I am 47 years old and my risk tolerance is high. So my stock to bond ratio is about 83/17.

Determine your stock-to-bond ratio and stick to it regardless of interest rates or market activity.