Recently I've encountered a number of investors with a variety of views, including; the U.S. growth cycle is just about to start; we are the cusp of hyper-inflation; stocks will benefit from a "Great Rotation" as naive investors finally realize there is no "value" in safer assets - namely treasury securities. In a nutshell, I find these arguments to be inconsistent with the actual data and outlook.
Despite increasingly ambitious programs by the Fed and global Central Banks over the past few years, growth has in fact continued to weaken. Q4-2012 U.S. GDP was down to -0.1% on an annualized basis, the lowest since the previous recession was declared over.
Meanwhile, important monetary measures such as money velocity show no sign of improvement and that has translated to lower inflation. U.S. CPI stands at 1.6%.
There are a number of bulls who talk about earnings strength and the resurgence of U.S. corporations. This would be fine, except for the fact that earnings are actually down on a year-over-year basis.
As measured by sell-side estimates, the Bulls are expecting S&P500 earnings to rapidly increase by the end of 2013. On an Operating basis, Analysts estimate the S&P500 to earn over $111/share this calendar year with quarterly earnings to exceed 30% on a year-over-year basis. This reacceleration would be the fastest since 2009.
Source: Standard and Poors
To achieve such goals, U.S. corporations would have to see substantial increases in top line growth or profitability. If you believe that top line growth will continue to weaken, the other way to grow earnings would be through an increase in margins, which are already stagnating at record levels. I find such an outcome highly improbable.
Then there is another set of bulls I have encountered. They are reasonable people who agree with the points I have made but find them irrelevant. Their investment thesis lies on the so-called "Great Rotation," and the omnipotence of the Bernanke. They reason that the Fed has made U.S. Treasuries so unappealing that investors will need to own stocks in order to make their objective returns. I ask those bulls why do supposedly poor returns from bonds automatically infer great returns from stocks?
There is plenty of academic evidence, which supports the fact that low bond yields imply low returns on all assets going forward. I encourage you to read the articles on this subject published in the Economist Buttonwood blog. In a nutshell, contrary to the cheerleading from CNBC, the evidence shows that the worst returns from equities come in low-yielding environments while the best returns come after periods of high real interest rates.
From a valuation perspective, analysts from Jeremy Grantham to John Hussman have outlined extensively that the long-term likely gains from U.S. shares is in the range of 4%. This is a simple outlook easily derived from earnings. Had investors listened to such basic Investment 101 math in 2000 or 2007, they would not have been surprised as to what transpired subsequently. But they were and they will likely to be again.
The reason is that the 4% per year isn't going to be linear, but rather, it will be met with a vicious bear market when investors realize that growth isn't coming back, and that in aggregate corporations have run out of ways to increase profitability absent top line growth.
As measured by real economic data, the sugar high provided by copious amounts of stimulus provided by the U.S. government and Fed continues to fade. Meanwhile, monetary velocity, an important precursor to inflation continues to fall. Despite the euphoria surrounding the latest surge in stocks, which continued after my Bears article, global bond markets have taken cue of the actual data and have held up far better than one would expect. Investors choose to ignore at their own peril the fact that important growth markets such as Emerging Markets complex (EEM) are actually negative YTD.
Going forward, the intermediate term "penalty" for owning safer assets such as Investment Grade bonds (LQD) and U.S. treasuries (TLT, IEF) is de minimis and hence these assets offer a far better reward:risk than assets such as stocks (SPY) or high-yield bonds (HYG). At economic and financial inflection points, bonds can protect or even increase the value of one's assets during periods of market deleveraging, as well as provide liquidity when one sees compelling value in risky assets.
Investors are making a huge mistake when they only focus on the absolute value of return from bonds. We are in a low-return world and hence the relative attractiveness of bonds should be analyzed with respect to the expected returns vs. the entire risky asset complex, which I believe will be poor at current levels.