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Quote 395 of 521

In 1959, exactly thirty years after the Great Crash, an event took
place that made absolutely no sense in the light of history.  Up to
the late 1950s, investors had received a higher income from owning
stocks than from owning bonds.  Every time the yields got close, the
dividend yield on common stocks moved back up over the bond yield.
Stock prices fell, so that a dollar invested in stocks brought more
income than it had brought previously.

That seemed as it should be.  After all, stocks are riskier than
bonds.  Bonds are <em>contracts</em> that specify precisely when the
borrower must repay the principal of the debt and provide the schedule
of interest payments.  If borrowers default on a bond contract, they
end up in bankruptcy, their credit ruined, and their assets under the
control of creditors.

With stocks, however, the shareholders' claim on the company's assets
has no substance until after the company's creditors have been
satisfied.  Stocks are perpetuities: they have no terminal date on
which the assets of the company must be distributed to the owners.
Moreover, stock dividends are paid at the pleasure of the board of
directors; the company has no obligation to pay dividends to the
stockholders.  Total dividends paid by publicly held companies were
cut on nineteen occasions between 1871 and 1929; they were slashed by
more than 50% from 1929 to 1933 and by about 40% in 1938.

So it is no wonder tha investors bought stocks only when they yielded
a higher income than bonds.  And no wonder that stock prices fell
every time the income from stocks came close to the income from bonds.

Until 1959, that is.  At that point, stock prices were soaring and
bond prices were falling.  This meant that the ratio of bond interest
to bond prices was shooting up and the ratio of stock dividens to
stock prices was declining.  The old relationship between bonds and
stocks vanished, opening up a gap so huge that ultimately bonds were
yielding more than stocks by an even greater margin than when stocks
had yielded more than bonds.

The cause of this reversal could not have been trivial.  Inflation was
the main factor that distinguished the present from the past.  From
1800 to 1940, the cost of living had risen an average of only 0.2% a
year and had actually declined on 69 occasions.  In 1940 the
cost-of-living index was only 28% higher than it had been 140 years
earlier.  Under such conditions, owning assets valued at a fixed
number of dollars was a delight; owning assets with no fixed dollar
value was highly risky.

The Second World War and its aftermath changed all that.  From 1941 to
1959, inflation averaged 4.0% a year, with the cost-of-living index
rising every year but one.  The relentlessly rising price level
transformed bonds from a financial instrument that had appeared
inviolate into an extremely risky investment.  By 1959, the price of
the 2 1/2% bonds the Treasury had issued in 1945 had falled from
$1,000 to $820--and that $820 bought only half as much as in 1949!

Meanwhile, stock dividends took off on a rapid climb, tripling between
1945 and 1959, with only one year of decline--and even that a mere 2%.
No longer did investors perceive stocks as a risky asset whose price
and income moved unpredictably.  The price paid for today's dividend
appeared increasingly irrelevant.  What mattered was the rising stream
of dividends that the future would bring.  Over time, those dividends
could be expected to exceed the interest payments from bonds, with a
commensurate rise the the capital value of the stocks.  The smart move
was to buy stocks at a premium because of the opportunities for growth
and inflation hedging they privided, and to pass up bonds with their
fixed-dollar yield.

<cite>Against the Odds</cite>, Peter L. Bernstein,
		   pp. 183-185

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