Who's Right: Bonds or Stocks?
A: Wow, talk about the bond markets and equity markets showing diverging signals. The bond markets are warning of deflationary risks and a slowdown, while equities just seem to do their irrational march higher. If history is any guide, its usually stock prices that are mispriced; like it was in late 2007. So what do you think is going on?
It was only 3 days ago that David Rosenberg said: "One has to question which asset class has it right – stocks or bonds. It is extremely difficult to square a sustained economic recovery which is what the equity bulls are telling us with a $38 billion 2-year note auction that was sold at a new record low-yield of 0.665% (as was the case on Tuesday)."
So, Are bonds right? Or are Stocks right? What is being priced in right now? Deflation or a simple pause in an otherwise ongoing recovery?
Barron's "Stocks Ignore Green Shoots' Turning Brown", discusses:
"What's remarkable is that the fixed-income and currency markets have taken due note of the signs of economic slowing, bringing down bond yields and the dollar, while the stock market rallies on its merry way. The Dow Jones Industrials have been able to hold onto Monday's 208-point pop through Tuesday and Wednesday's somnolent sessions, putting it within 6% of April's peaks.Is it possible bond markets are pricing in future weakness that triggers more QE by the fed, while stocks hold on to gains due to the powerful short term effects that comes with debt monetization policies? Will the chase for yield have a second wind, driving money into risk assets? Are the equity markets pricing that in now? But how can that be, if bond markets say money is fleeing to safety? This is the divergence and what I'm curious you guys think about it.
In the bond market, however, the two-year Treasury set another record low of 0.53% Tuesday and the benchmark 10-year note remains well under 3%, at 2.95% Wednesday. It is quite puzzling how equity investors see the proverbial glass more than half full while their counterparts in the fixed-income and currency markets see it half empty. "
Here are some new bears:
Pimco's Mohamed El-Erian via Bloomberg's, "Pimco’s El-Erian Says Chance of U.S. Deflation Is 25%":
“I do not think the deflation and double-dip is the baseline scenario, but I think it’s the risk scenario,” said El-Erian. Companies are accumulating cash and individuals are saving, making it tougher to counter deflation, El-Erian said. That reduction in private-sector spending makes government policies to stimulate the economy less effective, he said.
John Paulson via Bloomberg's, "Paulson Said to Pare Bets on Recovery as Main Funds Decline :
Billionaire hedge-fund manager John Paulson, whose $32 billion firm has been betting on an economic recovery by 2012, has pared bullish bets across his funds, according to a person briefed on the investments. Paulson also cut bullish bets in his largest funds after they declined this year, the person said, asking not to be identified because the information is private.Sounds like Paulson had a bunch of stop levels hit, will take the loss and doesn't trust this market right now. Here's what I know:
We Peaked --> We Crashed --> We Troughed --> We Reflated --> We Seem To Be Re-Deflating ---------> what's next?I think we are Re-Deflating and that this process will see the 'dull' side effects that come after periods of extreme stimulus. It will be more drawn out, less sexy, and not subject to the severity of the shocks we experienced in 2008-2009. I think it will last years and we will have small waves along the way. I'm certainly not in Prechter's camp!
Posted by In Debt We Trust
Thu Aug 5th, 2010 03:45 PM
Well, the stock bulls have a fair value case. I know its not trendy to talk fundamentals anymore but bear with me. With interest rates so low, the P/E values don't look so bloated anymore.
If interest rates are double digits, the present value of a dollar that you're going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4% (which happens to be the rate of a 30 year treasury). In other words, a dollar of future profit becomes that much more valuable.
There has also been much talk about Bernanke restarting the bond purchase program again. This is synonymous with steady low rates.
And many companies are sitting on cash hoards. That means they wil either have to invest in plant/equipment, labor (hah!), or start giving out bigger dividends.
http://www.cfo.com/article.cfm/14508819/c_14511422?f=home_todayinfinance
In fact, with bond yields so low and some asset classes like mortgage securities trading above par, then it seems buying a bunch of blue chip stocks that yield consistent divvies is the way to go. Just stuff them in your IRA and wait for capital appreciation. Few financial advisors will tell you this because they can't make any commissions off this strategy.
Posted by anonymous
Thu Aug 5th, 2010 04:35 PM
I agree that low interest rates that endure into the future increase the present value of future cash flows. However, the bond market is pricing a significant changce of deflation. I don't think low interest rates helps in that scenario as real interest rates would be higher and more importantly future cash flows will be smaller not just because of deflationary pricing but also the havoc that deflation can cause the economy.
Perhaps the explanation is simply that the gov. is pumping so much money into our system with continual support from the rest of the world that it is pushing all liquid asset classes up.
Posted by In Debt We Trust
Fri Aug 6th, 2010 12:50 PM
Anonymous,
Any idea how the Japanese market functioned as a parallel to the US? Did holders of Japanese stocks get comparable dividend returns?
Bill Gross says interest rates will be on hold for 2-3 years. He bases his analysis off the 2 year note.
"Gross, manager of the world’s biggest bond fund, has been benefitting from the steep yield curve by buying five-year Treasuries, holding them for a year before selling to pick up capital appreciation as well as interest income. His $239 billion Total Return Fund, which is attracting almost $1 billion a week from investors, has returned 13 percent in the past 12 months, beating 71 percent of its peers, Bloomberg data show. "
http://www.bloomberg.com/news/2010-08-06/pimco-s-gross-says-fed-isn-t-likely-to-raise-rates-for-two-to-three-years.html
Posted by lars
Fri Aug 6th, 2010 01:14 PM
All I can say is if you can answer this one right you will make a lot of money.
Me, I'm sitting generally on the sidelines. I'm not smart enough (or perhaps gutsy is more approriate) to place any meaningful size bets.
Posted by anonymous
Fri Aug 6th, 2010 04:07 PM
In Debt We Trust,
Looks like the Nikkei was following a choppy, downward trajectory after 1990, which appears to be continuing despite the surge until the end asset bubble in 2007. These returns should incorporate dividends.
I'm not sure if the quote by Bill Gross was directed at me, but if it was, I'm not sure what was meant by it. I took no position on interest rates, but merely stated that if there was deflation real rates would be high even if nominal rates held steady.
Posted by Fred
Fri Aug 6th, 2010 04:59 PM
I think many are confusing deflation, disinflation and deleveraging. What we are experiencing is deleveraging. Were we in a period of deflation, corporate revenues would reflect it more broadly and more strongly. As it is, they don't. In fact, they show the opposite. This doesn't mean we won't start to see a slowdown reflected by corporate sales but the fact remains that unlike the 1930s where both Europe and the US were in depression, the Chindia & Brazils are growing their internal economies handily. We invest in Brazil (financials/telecom/materials) and around China (materials). US equities that play into China's need for stuff (CAT and DE are great examples) will outperform. Equities that don't, will track the US economy.
My main issue with Bill Gross is he's changed his position how many times over the past 12 months? I count at least three fundamental shifts on bond yields, plus one shift to equities. He's right about one thing though, rates are going no where fast and that's an important thing for investors to understand because it requires a complete overhaul of basic allocation.
Posted by Noah
Fri Aug 6th, 2010 07:45 PM
I think deleveraging is a sympton of debt deflation. I also think corporations are seeing the fruits of major cost cutting and layoffs..mostly bottom line. Yes we will see top line growth compared to this time last year, but Im not sure how sustainable that will be and if revs will keep pace with current equity valuations
Posted by Sechel
Sat Aug 7th, 2010 09:26 AM
Noah, Your points made here and elsewhere about credit contraction , deleveraging and declines in asset values are spot on. Very separate from the CPI. Kudos that you have clarified this point.
The bond market by the way, in my opinion has been a far better indicator than the stock market at forecasting. One only has to look to the last few years to see this is going.
I'm concerned that the Fed may not have the right expectations, after several years of an excessive level of borrowing, above normal HPA and low credit standards it's only normal to expect a lowered level of the above while we revert to the long term means, and maybe undershoot the averages for a bit.
The bond market though is acting funny though. China and countries with dollar surplus reinvest regardless which keeps interest rates low and non-responsive to inflation and currency devaluation fears. Since the home owner is in the middle of the credit version of AA, he is not looking to borrow and credit standards reinforce that. What concerns me is the rising commodity markets and huge increases in currency point to reduced purchasing power.
Could this time be different and we see an environment where the dollar continues to decline against a basket of commodities and some currencies making life more expensive?
Posted by Sechel
Sat Aug 7th, 2010 09:44 AM
Great analysis,
We are deleveraging, and seeing a contraction in credit, asset values have come down...and if this is deflation then you are correct. However if you are looking to commodity prices and the average cost of living for the average joe(we don't buy houses every year)and consider how the cpi understates things, we do not have deflation.
Agree 100% on that we are deleveraging.
Posted by Fred
Sat Aug 7th, 2010 09:05 PM
One more point i'd make about commodities: the US and Europe are post-industrial. as such, our relationship to the basics is very different than economies that are on the front-end of massive infrastructure needs. China's desire to have a modern navy is a great example of why steel for example is going to be demanded regardless of what is happening elsewhere. the US could very well turn on the lights in 10 years and see copper at 6 or 7 bucks a pound, simply from demand fundamentals from emerging economies. metals in particular are finite and while the need to recycle will certainly increase, demand growth will propel materials for a long time.
someone should start a condo rental REIT in manhattan.
Posted by Sechel
Sun Aug 8th, 2010 06:30 AM
Japan debt to GDP has gone up while their personal savings rate has declined. As the second largest creditor nation to the u.s. it suggests to me that Japan will be forced to repatriate Yen to finance their own budget deficits which up to now have been financed by their domestic savings surplus. What we will see is the united states forced to pay more to finance its deficits which ultimately pushes us in the inflation camp. And Fred is right, regardless of how the u.s. economy performs Chinese demand will force the u.s to pay more for oil, steel, copper and other base commodities.
While the private sector is deleveraging, the government's actions will ultimately result in increased borrowing costs, a lower dolllar and higher prices. The current thinking that we need to focus on deflation is very myopic and needs to look beyond this crisis and make sure we're not building the next one.
Posted by mh23
Sun Aug 8th, 2010 09:55 AM
I believe that equities are still the best place to be, particularly if one has a longer time horizon, and they fully understand that their "growth" from investment over the next say five years will primarily come from dividend reinvestment.
Clearly Bernanke has made the decision to attempt to inflate us out of our current situation. Had he allowed deflationary forces to run their course beginning in 08, I believe it would have had a destabilizing impact on our society, as well as on most of the world as well. The challenge, of course, is whether or not he can succeed. I believe the answer is yes because we have a fiat currency that also has the benefit of being the world's reserve currency. Bernanke will print and do what he must to get us out of a deflationary spiral, even if it means a true devaluation of our currency. China has no choice but to play ball, because they realize that a U.S. mired in 20 years of deflation will be disastrous for them.
I further believe that if need be Bernanke would buy stocks, if he hasn't already, to prevent a sustained crash. As I posted earlier, were the S and P to crash to say 450 and stay there for three years it would mean the end of private and public pension funds, annuities, insurance companies, and the private banking system, they will not allow this to happen.
Now, the consequences of massive Q.E. may be nasty, but if Bernanke were to step aside, we would suffer an immediate deflationary collapse.
To use an obvious example, if one were to invest 100k in 50 different s and p companies yielding above 4% vs. a 10 year Treasury yielding let's say 2.88%, which portfolio will do better...will the dollars you get back in ten years be worth more than today, I doubt it.
Finally, in a private sector economy such as ours, business and the government are inextricably intersected. What the current Administration is doing, by being hostile to the creators of jobs while all the while wanting job creation, is terribly unproductive and itself deflationary, and it will not last forever. At some point government policies will be such as to truly encourage the deployment of capital and expansion, and when that shift occurs, it may signal the start of the next true secular bull market.
Posted by topper
Sun Aug 8th, 2010 02:11 PM
My question is:
What does this mean for Manhattan residential real estate?
Posted by cfranch
Sun Aug 8th, 2010 03:18 PM
It's quite possible that stocks and bonds are correct. it just depends on what time frame we are talking about. from a technical standpoint the stock market is poised to go higher. seasonally we are entering a typically bearish time of year and everyone seems to have their hands on the sell button. from a sentiment standpoint, excessive bearishness is bullish for stocks. the market is also applauding probable republican gains in congress and the prospect of gridlock. after the election(or just before)will be interesting for stocks.
Posted by Sechel
Sun Aug 8th, 2010 04:36 PM
Earnings short term seem optimistic. There's a very reasonable chance that on a short term horizon bonds do outperform, but longer term when you start out at record low coupons and a Fed bias toward inflation stocks have to do better.
As far as real estate, this is a mixed bag.
Of course commodity price increases(steel, lumber) point suggest a floor based on replacement cost. Add to this less new supply due to the same higher costs and less commercial financing and rising rental rates.
Of course the continued deleveraging of the consumer and the same restrictive lending on the residential side are negatives.
As far as real estate, no go-go years ahead but there should be some support once we get through the next 12 months.
Posted by Fred
Mon Aug 9th, 2010 10:02 AM
Topper - what stagflation means for low utility assets like real estate that are in aggregate 5x to 6x the national average, is not good. the only way these assets got to be so overvalued relative to Fairfield county and other suburban markets, is due to excessive leverage and a robust economy. they are both gone and not coming back. does it mean the reset will happen over night? not at all. it will be the deadly, quiet, steady slow boil kind of reset where a buyer in late 2009 will re-assess values in 2012 and realize that it would have made more sense to rent. the decision to unload, however, will remain blurry because no one likes to take losses and the promise of a quick turn around will overpower the reality of having bought something that is fundamentally not worth it. maybe these same buyers wake up in 2015 or 2016 and realize that expenses have gone up and values have slid another 10% but the net cost to own has gone up significantly.
here's the deal: most of the new condo product sitting vacant has a cost basis of around $900 to $1,000 / SF. it only got that high because land values quadrupled over a five year period leading into the peak. if you cut land values in half, you get a cost basis for new product close to $500 to $600 / sf for generally nice, well located, well built product. land is always the first to go up and last to go down. Manhattan has not reset in terms of land values yet but it will happen. when the new product resets, what happens to the older, pre-war inventory? it's not going to stay at $900 to $1,100/SF.
Posted by topper
Tue Aug 10th, 2010 03:02 PM
Interesting perspective, Fred.
Particularly interesting comments about land costs.
Wonder where Noah stands on this. It's gotta be real hard for a real estate person to express a bearish perspective. (That said, I think Noah has generally been pretty balanced over the years.)
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If history is any guide, its usually stock prices that are mispriced; like it was in late 2007. So what do you think is going on?
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