When to Move Back to Stocks?
By Wilfred J. Hahn , CIO
Our title echoes a question most will fondly remember from Sesame Street. Our query here, however, deals with much more ponderous matter than an assortment of animal pictures or some such. We’re referring here to the various factors underpinning bond markets these days. Some of these just don’t belong together. As we’ll show, this dissonance is likely to mark a major turning point to higher equity weightings. We’ll outline our reasoning on this point.
For the time being, a high bond weighting has again served to counteract equity market declines. As interest rates have plummeted to new lows — in the case of the U.S. long-term rates falling to 220-year lows at one point— bond holdings have soared in value. As such, our defensively postured portfolios have benefited from out-performance in recent months. While our views on bond market trends have been spot on these past 3 years, really, just how much lower can rates go? Yes, rates can fall further. But likely not much.
Consider these five trends as of late. We challenge you to pick “which are not like the other” … in other words, incompatible with expectation that bonds will continue to outperform stocks.
- Declining Credit Quality: Most sovereign bonds are steadily decreasing in quality (certainly so in the Western World, including the U.S.) Even Germany is likely to face a credit downgrade. This deterioration verges on the catastrophic as for the first time in 60 years, an O.E.C.D. country has defaulted. More are likely to do the same in the future.
- Declining Interest Rates: At the same time, interest rate yields (at least for those bonds still retaining the confidence of investors) continue to decline.
- Rising debt-to-GDP ratios: The volume of outstanding bonds in the U.S., Japan and other supposed safe havens continues to increase at a record real rate … to all-time highs relative to GDP. Even U.S. federal debt will soon slice through the 90% of GDP level (if not already).
- Unprecedentedly High Budget Deficits: Despite a high issuance of fixed-income securities, private fund flows into bonds are accelerating … not decreasing. In fact, in some instances, investors are willing the “pay” for storage costs, accepting a negative yield.
- Bond Market Outperformance: Despite all these preceding developments, and contrary to logical expectation, bond markets have continued to perform well … especially so, in comparison to stock markets.
Imaginative as one might like to be, common sense would argue that this last observation is one “that just doesn’t’ belong” according to the Sesame Street jingle. Outperforming bond markets are not sustainable.
That observation sharpens our attention, as anything “non-sustainable” should be a call to prepare for action. “What cannot continue, will stop” according to the famous Herb Stein quote. Yes, of course, timing is crucial. When primal investor emotions run rampant due to fears of bank bankruptcy, sovereign default, another economic recession … etc., there is no telling how extreme market distortions may yet become. But, as mentioned, what cannot continue will stop and stop it will … some day.
Consider the following comparatives between equities and bonds right now (we here focus upon U.S. statistics):
- The average dividend yield of the S&P 500 today is 2 times that of a 10-year U.S. treasury yield. Today, believe it or not, equities carry nearly the same volatility as bond markets, yet with double the yield!
- The cost of capital for large, quality companies is at a near-record low relative to their average return on capital and return on equity. In fact, corporate bond yields in the U.S. recently plumbed all-time lows. It now becomes compelling for “profit-maximizing” companies to buy back their own shares … every last one of them if they could.
- The member companies of the S&P 500 stock index now have an earnings yield near 7% real. The annual real interest rate on a 5-year U.S. treasury bond is minus 1% or so. Over time, the earnings yield has been a reasonable guide to long-term equity market performance. Even should corporate earnings decline by as much as a third, everything else being equal, the stock investment should be expected to outperform the bond by 5-6% per annum over a longer term period.
- Given the current rate of corporate stock buybacks and a slow IPO calendar, the supply of stocks is declining. Bonds on the other hand? They’re still making them as if they are going out of style.
- The shares of large MNC headquarter in the U.S. or Europe, can have a significant exposure to faster growth regions of the world. A government bond does not.
- Money flow shifts of late verge on the cataclysmic. Primal emotions are at work here, yet fears are logical. Investors have lost confidence in financial systems, banks, and the ability of monetary authorities to improve prospects. To date, nearly $1.5 trillion in money flows has swung from stocks to bonds in the U.S. mutual fund complex since 2007. As such, this is not a new trend. It is a shift that has been ongoing for a period of almost 5 years. Yet, this shift will not continue forever.
- Since time immemorial, the John-Q Public householder has usually rushed into the wrong investment asset, and at the wrong time. This is tragic … but understandable. History will likely show that they will be wrong again eventually.
- Popular Country (PC) bonds today (as opposed to those of Reprobate Countries (RC) are at record high prices. There is only 150 b.p. between the current market yield for a 10-year U.S. treasury bond and zero. Is this realistic? According to the estimates of Capital Economics , the outperformance of bonds over stocks in the first decade of this century has already surpassed that of the 1930s.
Which of the above eight factors don’t belong together? Actually all of them do. And, they all indicate that equity markets stand to sharply outperform bond markets markedly over a 3 to 5 year view. In our case, with an underweight in equities, it may not be too early to begin to increase holdings, especially so that investor pessimism remains deep. Eventually, future market actions will again serve to change sentiment and opinion amongst private and institutional investors.