Stocks vs. Bonds: An Update for the Current Market 12 comments
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I have lots of models, but I am only one person, so some of my models sit idle because I don’t have time to update them. Well, today, as I was reading Barron’s, I ran across the “Current Yield” column, and read this:
THE STOCK MARKET IS PRICED FOR a recession, but the bond market is priced for a depression. So says Rob Arnott, the brainiac who heads Research Affiliates, an institutional advisory.
That’s not hyperbole. Corporate bonds rated Baa or triple-B, the low end of investment grade by Moody’s and Standard & Poor’s designations, offer the biggest yield premium since the early 1930s, notes RBC Capital Markets.
That’s a problem for pulling the economy out of the credit crisis, but an opportunity for investors. Indeed, investment-grade corporates with near-record premiums arguably offer better return potential than common stocks, especially relative to their risks. “I haven’t seen this many markets offering double-digit opportunities since 1989-90 or ever so briefly in 2002,” says Arnott.
Part of it reflects the sheer weight of numbers. Corporates rated Baa yield about 550 basis points (5.5 percentage points) more than comparable Treasuries, nearly half again the spread in the 2002 post-WorldCom-Enron debacle and twice the average of post-war recessions.
You have to go back to the early 1930s, when Baa corporates yielded 700 basis points over Treasuries, to find a comparable situation. And notwithstanding all the hyperventilation in the media that this is worst financial crisis since the Great Depression, there’s never been such a full-court response to the threat of debt deflation — the $700 billion TARP, the bailout of Fannie Mae and Freddie Mac, the likelihood of trillion-dollar deficits and a doubling in the Federal Reserve’s balance sheet in just over two months.
I know things are bad in the corporate bond market, but I didn’t think it was that bad. This made me ask, “Hmm… what about my stocks versus bonds model?” That article is one of my better ones; a lot of time and effort got poured into that. So, I sat down and re-engineered the model, since, embarrassingly, the original model was lost.
The key question is whether the yield on BBB corporates is more than 3.9% higher than the earnings yield on the S&P 500. The answer is yes, and that means we should sell stocks and buy corporate bonds. But, here is the embarrassing thing for me. The first recent signal to sell stocks and buy bonds came in mid-August, but since I didn’t track the model regularly, I missed that. Since the original model worked off monthly data, even selling in early September would have preserved a lot of value. It is not as if corporate bonds have done well since August, but they have done much better than the S&P 500.
Here’s a graph summarizing 2008 via my model:
When the green line goes over 3.9%, it is time to buy corporate bonds. That is not a frequent occurrence; this model gives of signals only a few times per decade. Check out my original piece for more details.
So, with that, I offer my conclusions:
- It is still time to allocate money to corporate bonds versus equities. Where I have flexibility with my own money, I am allocating money away from Equity and to BBB investment grade and high yield corporates.
- Though there are a lot of reasons to worry, corporate yield spreads discount a lot of trouble.
- The model indicates a fair value of the S&P 500 at around 700. Uh, I’m not predicting that, but if we hang around at yield levels like this for long, yes, the equity market will adjust to the competition. More likely is the equity market treads water while corporates rally.
- A caveat I toss out is that all areas of the credit markets where the government is not meddling are disproportionately hurt, because investors are fleeing toward guaranteed areas. Thus, corporates are hurting.
- College endowments and other investors that hate to buy conventional assets should consider corporates now. It is my bet that a portfolio of low investment grade and junk grade corporates will outperform a 60/40 portfolio of Stocks and T-Notes.
- If you have the freedom to sell protection on a broad basket of corporates, this might be a good time to do it, when everyone else is scared to death. Time to insure corporate credit, perhaps.
- One more caveat before I am done. The rule has only been tested on data since 1953. It is not depression-proof. I hope to gather the data from that era and validate the formula, but that will be difficult.
So, be careful out there, and remember that corporate bonds typically do better than stocks in a prolonged bear market for credit. Yield levels like the present typically bode well for corporate bonds versus stocks.
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This article has 12 comments:
On Nov 09 06:04 PM Roger Knights wrote:
> What do you think about an arbitrage-type play of shorting long-term
> treasuries and buying BBB corporates? The great divergence in their
> yields shouldn't persist. (Right?)
The first four ticker symbols atop the article are ETFs for corporates. (Click on them for details.) LQD is for high-grade bonds; the other three (PHB, HYG, and the suggestively dubbed JNK) are for high-yield (BBB) bonds.
On Nov 09 09:22 PM The hand wrote:
> Thank you. Great post on bonds.
On Nov 09 08:56 PM softomic wrote:
> Thanks for posting your model. A chart with an upward trend. I
> love it. I'll definitely read this one over a few times to try and
> digest it. Sorry for the noob question, but what's the best way
> to get into "BBB investment grade and high yield corporates?"
Most of us, however, cannot issue CDSs or write Puts on corporate paper, and liquidity on options for the ETFs you mention is dismal. Are there other ways to take advantage of the high premiums for insuring bonds?
IndexUniverse.com:
biz.yahoo.com/indexuni...
Can You Trust Bond ETFs?
Monday October 13, 7:42 pm ET
By IndexUniverse Staff
Murray focuses on premiums and discounts in the fixed-income space, which is a huge story:Fixed-income ETFs are trading at wild variance with their underlying indexes.
ADVERTISEMENT
There are a variety of reasons why. The fixed-income market is so frozen right now that some bond price indexes are carrying stale data. At the same time, some ETFs are using "fair value" pricing to value their illiquid holdings, which introduces a layer of discretion into how each fund's assets are priced.
To be honest, it's hard to know exactly where these things should be trading. And that, to me, is a big problem.
The whole idea of investing in ETFs is that they give you clean access to various asset classes. You set your asset allocation—X% in stocks, Y% in bonds, Z% in commodities—and ETFs give you fair exposure to those markets.
Right now, they are not doing that.
Consider the three junk bond ETFs:the iShares iBoxx $ High Yield Corporate Bond (AMEX:HYG - News), SPDR Lehman High Yield Bond ETF (AMEX:JNK - News) and PowerShares High Yield Corporate Bond Portfolio (AMEX:PHB - News). All three funds track high-yield corporate bonds, holding portfolios of 50, 112 and 52 high-yield bonds, respectively. You'd think their returns would be similar.
But let's say you bought shares in each fund at the close of trading on October 3. Since then, through 3:30 p.m. ET on October 13, HYG is down about 8.5%, while PHB was down 15% and JNK was down 17%. That's an 8.5% swing in 10 days from top to bottom.
It's worse if you look intraday. At one point last Friday, HYG was down about 15%, JNK was down about 20% and PHB was down nearly 30%.
A 15% difference? Intraday? Are you serious?
Of the three funds, HYG appears to be trading the best. On an intraday basis it has been trading fairly smoothly, while the other two ETFs have vacillated wildly.
But with HYG trading at a massive discount to net asset value, who's to say.
Buyer beware.
The current yield on the SP500 is more like 3%, not 10%.
As for how to buy bonds, you can get a pro to manage a bond portfolio for you by investing in an open end mutual fund like Loomis Sayles. Many bond managers have fled risk into treasuries or agencies in the recent slide, not where you want to be. Instead the sweet spot is A rated or BBB rated corporates, and LS is a well managed fund aiming there.
That is the easy way. A harder way is to use some closed end funds trading at discounts sufficient to cover their generally higher management fees. Loan participation funds, high yield (junk) funds, distressed mortgage funds, and preferred stocks, are all ways to play the same spreads - but each is quite risky, and I'd only recommend 5% of a position in any one of them. With the bulk in something broader based and investment grade, like LS or Pimco.
Stone Fox Capital was talking about the _earnings_ yield of the S&P, not the dividend yield. Based on which estimates you pick for this year's earnings, the S&P is earning between 8 and 11%, corresponding to a P/E between 9 and 12.
The equity risk premium measures the difference between the earnings yield of equities and the yield on bonds. In most cases, risk-free treasuries are used for the calculation, but triple-B can be used as well, and even with the current high yields for corporate bonds, equity is still offers a substantial yield advantage.
The article you pasted in takes a pretty narrow view and ignores the possibilities that exist with the current yields. Being a young investor, I'm buying these steadily on the way down, reaping increasingly more pleasing payments along the way. I also have the luxury of a long horizon to let prices bottom out whenever they choose and sell at a profit later. I realize that not everyone has time on their side, but those people shouldn't be involved in junk funds for that very reason.