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Diversify Beyond Stocks, Bonds, Pimco Says

Stocks in this article: PASAX

NEW YORK ( TheStreet) -- Robert Arnott, manager of the Pimco All Asset Fund (PASAX), made waves in spring 2009 when the stock market was hitting bottom. He noted that bonds had outperformed stocks during the previous 40 years. Investors should be wary about relying heavily on stocks, he said.

Critics dismissed Arnott, saying the poor showing of stocks was a fluke. But Arnott is sticking to his guns. Speaking at the recent Morningstar Investment Conference, he retraced market history and argued that stocks could fare poorly in the coming decades. "The idea that stocks beat bonds by 5% per year is simply not true," he said.

Most investors have expected stocks to outdo bonds over long periods. Confidence in stocks has been based on the famous data generated by Ibbotson Associates. During the period from 1926 through 2009, large stocks returned 9.8% annually, while intermediate government bonds returned 5.3%, according to Ibbotson.

Arnott bases his pessimistic view on market history going back 200 years. During that time, stocks have outpaced bonds by about 2.5% annually, he said. But there were very long periods when stocks lagged bonds. "If you bought stocks in 1803, you would be behind bonds for the next 68 years," he said.

In recent years, there have been many periods when bonds kept pace with stocks. Since 1968, stocks and bonds have produced similar returns, Arnott said. While stocks have generally risen over the past two centuries, there have been many 10-year periods when equities stagnated.

How will investors fare in the next decade? Arnott says both stocks and bonds will likely produce subpar results because the current yields are low, an indication that prices are rich.

Bonds yield 4%, so investors should expect to get annual returns of around 4%, Arnott said. Stocks may not do better. He said stocks began the 1990s with a dividend yield of 6%, a sign of reasonable valuation. But when share prices rise, dividend yields fall. As the greatest bull market in history unfolded, dividend yields dropped, reaching a meager 1% in 2000. At that point, dividend yields were at all-time lows and price-to-earnings ratios were at record highs. With stocks expensive, it was not surprising that the S&P 500 languished in the past decade.

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