Why All The Love For Bonds?

It’s clear that economically things are getting better, not worse. In addition to gross domestic product numbers, credit spreads have returned to some semblance of “normal”, and the bond market has seen record refinancings. Yet stocks still sell below where they sold after Lehman failed, when the world was falling apart. Even in the week after Lehman collapsed, the S&P 500 traded as high as 1,255, more than 10 per cent higher than it is today.

In the parlance of Jesse Livermore, the early 20th century Wall Street trader, the path of least resistance for the stock market is higher, yet investor resistance to stocks as evidenced by what people are actually doing with their money remains resolutely in favour of bonds: money continues to be redeemed from US-oriented equity mutual funds, while flows into bond funds are running at record levels.

This affinity for bonds over stocks is understandable when looking at the past 10 years, but perverse, I believe, when looking at the likely course of the next 10. Bonds crushed stocks the past 10 years, with riskless Treasuries returning more than 6 per cent per year, while stocks lost money on average each year of the past 10. Ten years ago stocks were expensive; now they are not.

In the next decade, the story is likely to be quite different. As the economy gradually (or quickly) recovers, the Fed will remove the extraordinary monetary accommodation it provided during the crisis, and shrink its balance sheet. A neutral Fed funds rate would be in the 2.5 per cent range or thereabouts, perhaps higher. Long term, the ten-year Treasury ought to yield about the nominal growth rate of GDP, so somewhere in the 4.5 per cent to 5.5 per cent range, leading to substantial losses in Treasuries and probably investment grade corporates as well. High-yield bonds ought to do better, but they had their big move last year, rising over 50 per cent and providing the best returns relative to equities ever. All this, though, assumes benign inflation of 2 per cent to 3 per cent. If the inflation bears are right, bonds will be a disaster.

Stocks are quite a different story. After spending 10 years in the wilderness, high quality US large-cap stocks are cheap compared to bonds. Names such as Merck trade at 12 times this year’s earnings and yield more than 10-year Treasuries.

IBM has record earnings, trades at 12 times this year’s expected results, buys back shares every year, and has grown its dividend 25 per cent per year the past five years. Stocks have historically provided inflation protection that bonds cannot. Like Edgar Allan Poe’s famous short story, The Purloined Letter, these values are hidden in plain sight.

In addition to large cap stocks, so-called “low quality” recovery names are still quite attractive, with many of them trading below book value. Regional banks, for example, were among the worst stocks in an otherwise good year in 2009, but have begun 2010 strongly. Many of them have ample capital, will see loan and credit losses peak this year, yet trade below tangible book value and therefore with a negative deposit premium. This year should also see a merger boom, as corporate balance sheets are mostly flush with cash, and profits are again headed higher. Healthcare and tech are fertile hunting grounds, as well.

Broadly, I think the names that trade at low valuations on traditional accounting factors such as low price-to-earnings, low price-to-book, and low price-to-cash flow will be the winners this year. Companies whose stock prices already discount mid-cycle earnings, as many materials and industrial cyclicals do, may fare less well. Industrial metals prices have had very large moves, as has oil - both appear to be well ahead of fundamentals. If the Chinese continue their tightening cycle faster than the markets currently anticipate, things could quickly unravel. It’s important to keep in mind that China is structurally short oil, and higher prices are not its friend.

The dollar remains a wild card that could underpin a strong stock market if its new-found strength against the euro continues, as investors in Europe appear to be substantially underweight US equities. A euro at 1.25 to the dollar at the end of this year would not be a surprise, and it still would not be cheap.

I think 2010 will be a good year for stocks, and a challenging one for bonds. Low inflation, good economic growth, ample liquidity, rising corporate profits, attractive valuations, and continued investor scepticism should combine to move the market higher, perhaps substantially so. The current consensus appears to have the market up high single to low double digits. If the consensus is wrong, I think it will be because it is too low, not too high. At least that is what the facts, data, and evidence would lead one to believe, if one were unencumbered by a theory that says otherwise....