David Gaffen

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Can Stocks and Bonds Celebrate Together?

August 26, 2009

So who is right and who is wrong?The stock market has rallied by more than 50 percent in the last five months. But bond market yields currently hover around 3.4%, and while that’s nowhere near close to the crisis-induced record low reached at the end of 2008, a graph of the 10-year note’s yield shows that it remains lower than almost any point other than when prices spiked in the wake of the Lehman Brothers collapse.

Ten-year yields remain in a tight range.

Ten-year yields remain in a tight range.

Equity investors would rightly point to better housing data and stronger economic indicators as a sign that things are looking up. The bond market, meanwhile, continues to worry that the outlook remains grim. Yields have been bound in a range between 3.4% and 4% since late May, despite the dark warnings from those “bond vigilantes” that believe crushing U.S. debt will turn off our major foreign benefactors.

But a rally in both the bond and stock markets was a fixture of the financial scene for a number of years. Strong growth coupled with low inflation created the so-called Goldilocks scenario, where bond yields could rally, and stocks flourished in part due to lower borrowing costs.

Whether that can be repeated for any length of time remains to be seen. Stocks have rebounded from an awful several months but still remain about one-third below their peak. Yields are low, but 3.4% has been the floor, even with the inducement of the Federal Reserve buying Treasury securities.

The possibility exists that in coming years both stocks and bonds will deliver mediocre returns. Bonds have benefited from the intermittent breakouts of risk aversion that accompany bad economic reports or brief stock swoons. And it seems less likely that equities can keep running at this pace with the outlook for earnings – particularly profit growth – so unsettled.

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