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By Pat Dorsey, CFA | 10-07-2010 03:39 PM

Investors Going Overboard with Bonds

Investors piling into bonds are likely paying too much attention to what happened in the past and too little attention to where they are starting from today, say Morningstar's Pat Dorsey and John Rekenthaler.

Securities mentioned in this video

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar.

Earlier this week, John Rekenthaler, who is joining me today, the vice president of research at Morningstar, e-mailed me an interesting little quote from an interview that Warren Buffett did on CNBC, and that's sparked kind of fascinating e-mail chain that we had. Why don't you tell me what the quote was, John?

John Rekenthaler: Well, Warren was speaking at Fortune's Most Powerful Women group or gathering.

Dorsey: Has Warren had an operation recently that I am not aware of?

Rekenthaler: Apparently, he is not one of the most powerful women, but he is definitely one of the most powerful men. He said that it's become quite clear to him that stocks are cheaper than bonds, which of course there was then a headline that tied in Warren to pronouncing on the bond bubble. I mean, there has been a lot of talk about a bond bubble.

Now, I didn't think he went that far when you look through there. He just said, he felt stocks were cheaper than bonds, and he couldn't see really any reason to add to a bond portfolio at this stage.

Dorsey: Right. That's the point that I think I've been making and you've been making as well a lot in communications we've had with investors, and certainly in videos I've done on the site--that why would you be settling for a 4% coupon that's fixed, for say, investment-grade debt right now when you could be getting a 7%, 8%, 10% coupon that grows over time on equities. It just seems like, as you put it to me, first grade math.

Rekenthaler: Yes. It's pretty straightforward stuff, and I'll touch on that.

But first, I guess, where I should start is pointing out that I always like how Buffett phrases things. And it's easy to say bubble, it's easy to say it, and it's easy to identify it looking backwards. It's hard at the time. The first few years I was at Morningstar had many people with many years experience in the stock market saying we were in a stock market bubble in 1989, 1990, 1992, and so forth, because they have these historic valuation measures and stocks were expensive compared to their measures, which always seem to have lots of data points in 1937 or something like that.

But the point being, I stayed clear off bubble, and I don't think it's a bond bubble. If we want to look at a bubble, we can look at 1950. I went back and looked at 1950. The yield on the S&P 500 was 7% and on Treasuries was 2.5%. Now, when you can get three times the yield on the stock market that you can on Treasuries, you're probably in an extreme situation.

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