Stocks from Venus, bonds from Mars
Forget about politics, the biggest divide in the U.S. is between stock and bond investors, who aren’t so much arguing as speaking entirely different languages.
Stocks, while about flat for the year, are priced moderately cheaply by historical standards, implying that investors think they have a reasonable, if not spectacular, outlook for the next couple of years.
Earnings are strong, and forward looking estimates of earnings, while coming somewhat off the boil, are still rosy and cash balances are high.
Bonds, in contrast, are telling you that the U.S. will be dicing with deflation and recession over the same period, painting a landscape in which the great thing is to hang on to your capital.
Check this out: The yield on a ten-year U.S. government bond is 2.58 percent while the S&P 500 has an earnings yield, measured on a standard accounting basis, of 6.23 percent.
Somebody, to put it mildly, is going to end up disappointed.
There is simply no way that earnings can stay that high relative to stock prices while bond yields stay that low. If the earnings can be sustained, stock prices will rise. If that scenario plays out, here’s betting the whole deflation and recession thing has given way to either moderate growth and even possibly inflation.
If so, you will not want to be one of the people who two weeks ago bought a three year bond from IBM that yields – wait for it — 1.0 percent or the kind of coupon that makes you think Mr. Roosevelt must speaking on the wireless again.
Nor, if the stock market proves more right than wrong, will you want to be one of the people holding AAA non-financial debt, which now yields 4.72 percent, the lowest in almost 45 years.
So, are bonds in a bubble and should investors reverse course and re-allocate to stocks?
Probably not. The bond market is not in a panic and the kinds of returns being generated are not the kind we usually associate with speculative frenzy. In fact the one real scene of frenzy in the bond market is in high-yield, or junk bonds, where issuance is positively booming.
Interestingly, though as borrowers are jumping over each other to sell high yield bonds, they are doing it into a market that is requiring them to pay a heck of a lot in interest for the privilege.
Despite the fact that high-yield defaults are less than half their historic average, the yield spread on junk bonds compared to U.S. Treasuries is about 60 basis points wider than their average over the past 12 years, according to BNP Paribas Asset Management global credit strategist Martin Fridson, who said the discrepancy is signalling about a one in four chance of a recession.
TIPS OF THE ICEBERGS
A look at the market for Treasury Inflation-Protected Securities (TIPS), bonds which pay more or less based on actual consumer price inflation, underscores the extreme disconnect between stocks and bonds
The real yield on ten-year TIPS is only 1.0 percent, while five year TIPS yield essentially zero and three-year TIPS have a negative yield.
If those yields come anywhere near to reality, it will be a very fine company indeed which can produce competitive returns for its stockholders.
TIPS are implying, at best, that there is absolutely nothing to fear from inflation and at worst, that we are heading into a period of deflation and a sustained period of very low growth.
Jim Leviss, a bond fund manager at M&G in London notes that TIPS contains two features that are extremely valuable under current circumstances.
Though real yields on TIPS are extremely low, investors always get back 100 cents on the dollar, even if inflation turns negative and those 100 cents are growing in purchasing power, making it a hedge against deflation. At the same time, TIPS, by their nature, offer protection against inflation, which many believe could get out of control if the Fed is forced to take more desperate measures.
Analyzing the meaning of the bond market is a heck of a lot more difficult now, however, for the simple reason that quantitative easing is distorting its message.
As the Federal Reserve buys government bonds they artificially lower what we used to think of as the risk-free rate. This is intended to induce us to take on more risk in order to revive the economy, but it might also make government bonds give artificially gloomy signals while other risk assets are made artificially cheerful.
In the end, the stock and bond market may well split the difference, but, as always, it pays to apply a heavy discount to almost everything you are told about stocks by all of the people whose livelihood depends on you confusing your own best interests with theirs.