Buy stocks, sell bonds

By Felix Salmon
August 8, 2011

S&P downgraded the U.S. on Friday evening; the markets then had all weekend to work out what that meant, with the verdict arriving when markets opened Monday morning: stocks fell about 1.5% or so. That was about right, it seemed to me: the downgrade was important enough to take seriously, but not important enough to panic about.

And then stocks just kept on falling. As I write this, the S&P 500 is down 5.6% on Monday, wiping out a year’s worth of gains. That’s a big move, and no one knows where it might end.

From a market-dynamics perspective, we’re now in the world of momentum trades and falling knives. This isn’t a repricing of risk based on new information: it’s a trader’s market, which will move in the direction of inflicting the maximum amount of pain on the maximum number of people.

I’m not saying that this is an overreaction — the U.S. downgrade is a legitimately momentous event, and will have a large number of unknowable repercussions. A world which highly values predictability and certainty has become significantly less predictable and certain than it was last week. Does that mean that U.S. stocks are worth 20% less than they were at the market highs around 1,370 on the S&P? No — and that’s one reason I’m looking at this move more like a 20%-off-sale than a sign of incipient economic Armageddon.

What’s fascinating is the way in which all of the carnage is happening in the stock market, rather than the bond market: Treasuries themselves — the very instruments which were just downgraded — are up on the day, with the 10-year bond yielding a shockingly low 2.36%.

Faced with all this, what’s an individual investor to do? The first best answer in all such situations is always the same: nothing. Times of high volatility and market panic are a great time to go off to the beach and try to forget about your retirement portfolio — you want a clear head and a long-term horizon, rather than an obsession about what markets did today.

That said, however, one strategy might make sense, given what’s happened to stock and bond markets of late: a simple portfolio rebalancing. What’s your ratio of stocks to bonds? If you had it where you wanted it a few months ago, then right now, with stocks down and bonds up since then, you’re likely overweight bonds. So sell some bonds (they’re very expensive, thanks to all this panic), and buy stocks with the proceeds, until you’re back to your optimal asset allocation.

And while you’re at it, you might want to revisit that asset allocation, and ask yourself whether having all that money in bonds is particularly smart. If you’re invested for the long term — a 10-year time horizon, say — then a 2.4% yield over those 10 years is utterly pathetic, and can easily get eaten away by inflation alone. Meanwhile, with expected earnings of $99.83 per share this year, the earnings yield on the S&P 500 is a whopping 8.8%.

This is one of those times that stocks genuinely look safer than bonds. They might well go down, of course, in the short term. But on a relative-value basis, they’re looking decidedly cheap.

31 comments

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You said “a 2.4% yield over those 10 years is utterly pathetic” — but I’m pretty sure a lot of people said the same about Japanese Government Bonds in 1997 — with grinding deflation and 10-year rates now at 1.1% (despite an S&P downgrade), yielding an effective yield (in USD) of around 5.5% per annum, it doesn’t look so bad now….

Posted by draghkhar | Report as abusive

Gosh, Brad DeLong said the same thing, though less emphatically, on the 4th. (http://delong.typepad.com/sdj/2011/08/b uy-equities-huskies-buy.html)

I’m certain he’ll be correct, on a Very Long-Term Basis, one of these days as well. My unscientific survey says that the buying opportunities are still at least 500–oops, 350–points away. And that’s not among those who look for the Absolute Bottom.

Posted by klhoughton | Report as abusive

In the 25 minutes since I last looked, the Dow dropped another 50 points.

As with 1987, I think I’ll wait until the option buyers in Hong Kong decide that stocks are inexpensive. And while we can hope that will be tonight (Nagasaki morning), it might not yet be the way to bet.

Posted by klhoughton | Report as abusive

If you buy (stocks) now, I should think the odds are greater that you’re buying into a declining position with no bottom, than any other alternative narratives.

Posted by GRRR | Report as abusive

If that was an 8.8% dividend yield, I’d be a buyer. But earnings are not dividends, and forward earnings are not so rosy anymore.

Posted by maynardGkeynes | Report as abusive

According to Shiller’s CAPE (10 yr real PE)and Tobin’s Q value, the S&P 500 has been significantly over-valued for most of the past year. It is only dropping now to the bottom edge of the upper 20% quintile.

It is important to remember that the only reason the upper quintile range is as high as it is is because the stock market spent so much of the past 12 years in over-valued territory (which explains two 50%+ drops in that period with the Fed anxiously re-inflating it after each crash).

US large-cap stocks have been doing well over the past couple of years because they have diversified overseas and have a lot of earnings in foreign currencies that are increasing in value against a dropping US dollar. If the US is dropping into recession, those earnings will likely drop, both at home and overseas, and plunging markets will likely suck money back into the US raising the US dollar like in 2008. At that point, earnings will likely drop, so the stock market tanking will feed on itself.

There is still a good chance that we will retest S&P 666 over the next couple of years.

Posted by ErnieD | Report as abusive

I like the smell of blood in the water as much as the next guy, but I’m not utterly persuaded that stocks are at attractive prices. To the contrary, I thought they were expensive–if not downright frothy–a couple of months ago, when they were still at their QE2-goosed highs.

I buy some stock every two weeks, and that’s not changing. But I’m not certain it’s time to rebalance or reallocate just yet…I dislike rash moves in any event. My standard game plan is to rebalance once a year, around the end of January. And I’m not sure I want to change that. Stocks may well be closer to their underlying values today than they were last week.

Posted by ckbryant | Report as abusive

Sellers need buyers.Currently we have reduced supply of naive buyers.One of reasons s why markets will keep going down and sideways.

Posted by Professor51 | Report as abusive

I’ve been steadily selling stocks since October 2010 (last sale was mid-July). Now the closing prices today look a little better than when I began paring my equity exposure, but not by THAT big a margin. If they drop another 10% (which could happen by the end of the week), they’ll be fairly valued again. Maybe. *IF* forward earnings estimates aren’t revised downward.

I’ll likely be buying over the next three months, as cash comes free, but I don’t see any urgency at this point.

Posted by TFF | Report as abusive

What use is a dividend that rises if one bears a loss of principal. Missing from your commentary is the fact that stocks are just expensive here which according to John Hussman and Jeremy Grantham are priced to deliver only about 5% over the next ten years which is not that great. Investors are actually being logical by waiting for lower stock prices before jumping back in.

Posted by Sechel | Report as abusive

Great advice Felix… But it’s only good for all those millionaire’s who have high-paying jobs….
Not for us stiff’s who’s job got outsourced, and whose unemployment ran out….
I hope the market drops another 1500 or 3000 points…

Posted by edgyinchina | Report as abusive

Markets always overdo things. Too far up, too far down. Wait until Wednesday before you make any judgements. Let the panic subside.

Posted by FifthDecade | Report as abusive

“Great advice Felix… But it’s only good for all those millionaire’s who have high-paying jobs…. Not for us stiff’s who’s job got outsourced, and whose unemployment ran out….I hope the market drops another 1500 or 3000 points.”

Humm… thanks for the good vibes edgyinchina… remember that everything is connected. The market dropping another 15%-30% means more tax losses offsetting ordinary income at the end of the year. That means less tax rev for the already underfunded goverment… and that likely means more cutbacks in services like 52 weeks to find paid work instead of 99 for instance.

As for you Felix… should you grow board with being the best economic blogger on the web and decide to become a financial advisor I think you will be in the top 1% of my field. Great title for todays great post!

Lastly for my favorate commenter TFF… I know that you are right about my being richer when asset prices are cheaper and poorer when they are pricey. I’m 30 years from normal retirement age and I hope to work well past that date by choice… so I know cheaper the valuation ratios of equities get the better it is for me because the earnings will compound faster…
… so why do I feal like I got thrown down 5 flights of stairs…. uggga…

…time for a drink.

Posted by y2kurtus | Report as abusive

A couple of points that I disagree with.

Felix’s analysis is superficial here. Not only are US treasury bills and notes increasing in value in the face of an S&P downgrade, but there is a great amount of cash sitting on the sidelines in company accounts. Mellon bank of NY is even charging negative interest rates albeit on deposits over $50m. And I believe ‘insiders’ have been selling a lot of stock lately.

There is real fear out there, but what are investors afraid of, especially those who should know? According to Spengler at Atimes, you need look no farther than the hedge funds. He may be right, or some other institutions could be in serious trouble, and what we are witnessing is the beginning of a fire sale. Such sales come to an end, but are devastating in the short term, and the healing process takes time.

My second point is the S&P downgrade of US debt is something more than you just take seriously. It rates in the category of events that I never expected to see in my lifetime. You know, like when the Berlin wall came down, the Soviet Union collapsed, etc. The shock of this event hasn’t sunk in quite yet, but just give it a few days before American citizens realize that they are on the way to being viewed as a new Banana Republic. The reaction should be breathtaking.

In any case, the rest of August will be anything but the dog days of Summer.

Robert W. McCoy

Posted by rwmccoy | Report as abusive

Right on, McCoy!
Americans are sore losers and right now they are in serious denial.
The American dream has turned into the American nightmare and it has only just begun.
Repossessing agents are advertising U.S. houses for sale in Asia at USD200,000 for a 5-house package. Looks like Wal-Mart pricing strategy. Nothing to joke about.
It reflects what the U.S. has STARTED to become. You need to offload your garbage in someone’s backyard. The worse is yet to come. Apple may sell more i-things than U.S. homebuilders sell houses, but that’s not going to save the economy.

Posted by doctorjay317 | Report as abusive

Just a really awful post. Ignoring your faulty ‘analysis,’ is your solution really to go bury your head in the sand? That’s the best you can come up with? Wow. How about hedging? I suppose that takes a bit of effort, something this post shows you don’t do.

Just wow.

Posted by ReeceMarken | Report as abusive

p.s. after the titanic hit the iceberg, on a relative basis, the stern was where you wanted to be.

Posted by ReeceMarken | Report as abusive

“What’s fascinating is the way in which all of the carnage is happening in the stock market, rather than the bond market: Treasuries themselves — the very instruments which were just downgraded — are up on the day, with the 10-year bond yielding a shockingly low 2.36%.”

So why are you assuming the drop is because of the downgrade and not because of double dip fears in the U.S. and Europe? I know believing in efficient markets isn’t fashionable these days, but to believe the story that today’s events were because of S&P is to believe that investors are anti-rational.

Posted by AASH | Report as abusive

I defend Felix. 2.4% is pathetic when you have inflation. I don’t hold any Thai or Filipino shares unless they have a PE of less than 8, a yield north of 7% and are 100% hooked into the consumption led growth of the 1 billion citizens of the ASEAN trading bloc. Plus there is a 3/7 of dividends received kickback of the Thai corporate tax if you use a Thai broker and enjoy the beaches in Thailand for more than 180 days in any one tax year.

Posted by threeRivers | Report as abusive

Not so simple,Felix.Which stocks?When? Which bonds?
And you take in account only US securities.In UK,Germany,
France,Australia you can find bonds with yields up to 5-6%.
USD is better?This is just an opinion,to be demonstrate.
World is changing,the economic equilibrium is going to East.
I don’t care about AAA,that are judgements for no brainers.

Posted by SteveP | Report as abusive

Please people, Felix is just reminding everyone of Ben Graham’s sage advice. Do a little reading from a real book instead of internet trading sites.

Posted by jrg | Report as abusive

Pretty much nonsense. The only reason to buy stocks would be a non-economic stochastic reason such as a central planning FED buying equity or handing out tax dollars to the croupier to buy equity. Without addressing the fundamental structural issues there is no way we won’t continue this see-saw process until the taxpayer and nation are completely broke.

Posted by KarlMarx | Report as abusive

I moved into 80% cash in mid-July when it became clear that we headed for a train wreck and that even if a deal did get done, the cure would be worse than the disease.

What I find interesting in Felix’s analysis is that he uses the top of the market (i.e. S&P 1370) as his baseline to argue that the market is now having a 20% off sale, which is very faulty logic.

Maybe the baseline is even lower than where the market is now and S&P 1370 represents the fact that it has been overvalued for quite a while. Who knows? After all, up until the recent correction, the market was trading HIGHER than where it was on the day that Bear Stearns collapsed, almost as if the financial crisis and 9.1% unemployment never happened.

Posted by mfw13 | Report as abusive

“I know cheaper the valuation ratios of equities get the better it is for me because the earnings will compound faster… so why do I feal like I got thrown down 5 flights of stairs….”

I know the feeling, y2kurtus. My head is still spinning right now, which is part of why I’m delaying any new purchases. Want to be more confident in my valuations before I decide where to commit the 10% cash I have available.

While I haven’t ever visited a financial advisor, I imagine they generally have planning software to prepare for retirement? Working off current assets, future contributions, as well as estimates for inflation and future returns? I have a spreadsheet that does the same — and which would likely tell me that the last three weeks have pushed my potential retirement back by a year. Yet the reality is that nothing has changed. Any suggestions how to model expected long-term returns to reflect this truth? Doesn’t need to be an accurate model, since I’m not particularly relying on its conclusions. Just something that will offer a counter-cyclic ray of hope.

“What I find interesting in Felix’s analysis is that he uses the top of the market (i.e. S&P 1370) as his baseline to argue that the market is now having a 20% off sale, which is very faulty logic.”

Agreed. A 20%-off sale at Bed Bath & Beyond is pretty typical, not a great deal. I feel the same about this market. It is a better price, not a good price.

Posted by TFF | Report as abusive

I generally enjoy your posts but this one is pretty poor for you.

The debt ceiling debacle had no direct effect upon yields as default was never going to happen. The US issues debt in its own currency and will always be able to make payments. Instead, this crisis clearly informed everyone that the US government does not have the ability to improve the economy fiscally or to make a collective effort on jobs. That confirmation combined with an Italian balancing act, unrest in the UK, fears of a return to recession, burgeoning TBTF real estate litigation, and a market run up over the last 27 months simply sparked a significant move to safety. That’s why you see yields and the market down.

Lastly, your attempt to provide financial advisor type advice seems to be based upon the idea that the market was at fair value 10 trading days ago rather than at a point where it had run up remarkably over the previous 29 months.

Thanks for all the great posts but this one falls short in my opinion.

Posted by badbisco363 | Report as abusive

“In breaking new, the downgrade of the United States Government Debt from AAA to AA has caused a market drop of 600 points. Fortunately, an expert in vowels, Mr. Pat Sajak, has indicated willingness to sell us the missing A for $2 trillion.
We await word from the government on this important offer.”

==RED

Posted by REDruin | Report as abusive

There are some loose ends here. First of all, if the Senate Banking Committee is going to hold hearings on the specific competence of S&P on sovereign debt, it should carefully consider ABC News video of the David Beers interview in which he failed to give a clear explanation of his notorious mistake.

In fact, Beers snapped that he had to be allowed to finish his explanation, but then, after getting so worked up, went on to other matters. As if there is no coherent explanation. Nor do I believe there is one. Ezra Klein at The Washington Post challenged Beers about the incoherence of the versions of the S&P rationale, and the manifest resulting incoherence of the final product, but could not get a sound response.

S&P is notably unqualified to give political advice. Nor is it, out of its own mouth, always capable of functioning rationally in doing its math. Therefore, this is a case of severe dysfunction that must be ameliorated by hearings at the Senate Banking Committee. If S&P’s business must be crushed, so be it. At least, a sharp downgrade is indicated. (Perhaps Portugal could help).

I am surprised that Felix does not have this story in focus. It is a significant turn in events when Klein reverses himself in tone to this degree.

Posted by ClaytonBurns | Report as abusive

Let me tie up one of those loose ends for you Clayton, the senate banking hearings are going to be first postponed and then quietly canceled. If they were actually held they would serve only to highlight the difference between a true AAA soverign credit like Germany and our own goverment. Their debt to GDP is lower, their economy is stronger, their budget is much more structurally sound, and even their multi-party system of goverment acts much more mature than our congress.

Even asking grandstanding accusatory 5 minute questions and cutting off Mr. Beers twenty seconds into his answers it would be crystal clear to the 1% of the population watching that the S&P had the high ground.

No country can afford pepertual war while at the same time providing goods and services to 40% of the total population not productively employed. Anyone who disagrees with one letter of the previous sentence does not understand basic mathmatics and should not be taken seriously.

Our grandparrents live through a depression and two world wars… we’ll get through this mess. Just got to start planning ahead a bit more and making better decisions.

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Posted by chasingbeta | Report as abusive

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