Reasons For Caution For Stock Market Investors, And Hope For Bond Investors

Jun. 4.13 | About: SPDR S&P (SPY)

Introduction: It's looking at least a bit like 2011, but from a base of both higher stock prices and lower interest rates - but also much lower current inflation. Fed funds have been dropping again, and there's a new investment theme, as seems to be case every year lately.

In late 2010 and the first months of 2011, the theme was inflation and inflation hedges -- silver, gold, oil -- all due to QE2, allegedly. That didn't last beyond the summer, though. Last year, it seemed as though the theme most of the year was one stock named for a fruit. This year, the theme I perceive is the stock market itself. This article argues that stocks have done so well for so long for the last 20 years, despite valuations that were already high, that they will be challenged to continue to provide expected 7% or so expected annual returns perhaps for the next two decades.

The stock market risk/reward may be somewhat the reverse of what interested me to get into the stock market as a highly indebted medical student in August, 1979. I had received a very small inheritance and had been given advice from various quarters that it was a good idea for a doctor-in-training to begin to learn about how to handle money. What specifically attracted me to stocks was learning how poorly they had performed going back to, say, 1925. As I recall the statistics I saw, total stock market returns had only been around 7%-8%. However, inflation, nominal GDP growth, and interest rates were in double digits. It looked reasonable to expect a period of double-digit returns from stocks to catch up with the world as we then knew it. It appeared then that reward exceeded risk.

Now risk versus reward appears much more balanced, or tilted toward risk exceeding reward. The fact that fixed income and cash interest rates are so low reflects sluggish GDP growth, so that's really no help to stocks. The core reason for caution on stocks for the long run is:

Prolonged out-performance rarely lasts: Since dividends are subtractions from a stock price, merely looking at prices of stock market indices is irrelevant. More important these days, stock buybacks are also direct payments to (selling) shareholders and deplete the corporation's cash identically to dividends. Thus both dividend payouts and share buybacks must be considered in assessing stock market performance, in addition to market prices.

In 2009, the New York Times reported that in prior years, buybacks used up twice as much corporate cash as dividends. I don't know what the exact numbers are, but we're going to end up with approximate valuations, so I'm going to assume that the S&P companies have averaged a 2% dividend payout ever since the SPDR S&P 500 ETF (NYSEARCA:SPY) came into being as the first ETF in early 1993. If buybacks accounted for 50% more corporate cash that was returned to shareholders, then this is the total return to shareholders via the SPY at current market prices:

The 2% dividends plus 3% buybacks (a guess) equals 5% annually. The price return is as follows. The SPY traded at $43.94 on Jan. 29, 1993. It is now $163.45. That's about 6.65% per year. So total return, which includes small charges to manage the SPY ETF, is about 11.6% annually. This of course far exceeds the growth of business sales, which from March 1993 to March 2013 grew at 4.17% annually.

Stock market total returns to shareholders thus have at least doubled the growth in sales for the past 20 years, at least based on the above-linked U.S. sales data from the Census Department. The excess returns implied by an 11+% annual return therefore come mostly from higher after-tax corporate profits and a higher valuation.

The problem is that 1993 valuations were already near a record: Here's the chart of S&P dividend yields since 1871 (repeat link as above, for convenience). The 3% level that was hit in 1993 was the lowest level stocks reached before the crashes of 1929 and 1987. Hmmm:

S&P 500 Dividend Yield Chart

Something was different, and it wasn't merely dividend yields being low because of a huge change in corporate payout policy. The following chart showing stock market valuation using a "Shiller P/E" ("PE10") as well as a version of Tobin's Q shows that by 1993, valuations without considering dividend payout policy were already near levels of important stock market tops, not stock markets ready to surge.

From Andrew Smithers' chart:

Click to enlarge

Since the Federal Reserve became operational in 1914, more than half the years that both the red and the blue lines were above what is now calculated as their long-term average came since 1990.

Might the bubble come back as big as in 2000? Maybe, but there are some notable similarities between the public mood in 1999 and 1929 that are absent today. Both came a decade after the seeming end of wars. War was even renounced by many nations in 1928. Both the '20s and the '90s were decades of innovation and consumerism; the future appeared to be so bright one needed shades to see it. The Fed eased big-time in 1927, as well as in 1995 and again in 1998. There was a millennial fervor in 1999 that can only come again in 2999. So there are reasons to be skeptical that the voices saying that this stock market is probably not topping because a '90s-type mania is not visibly present are correct.

But aren't bonds in a bubble? Given low inflation, probably not, especially because most of us who own bonds anticipate that their real yields may be negative. Bonds are within their long-term trading range again, though just barely. Most of us associated investment bubbles with enthusiasm, for which bonds have virtually none. Yields are simply very low. But presumably a solid debt instrument gives one's money back, something that is never promised by a stock market investment.

As this chart shows, what was arguably the "real" bond "bubble" began when yields exploded to post-Civil War highs in the late 1960s and stayed there into 2000 - an over-thirty year explosion to essentially unseen yield levels:

10 Year Treasury Rate Chart

The last time bond yields got to this range, they stayed below 3% for about 25 years. So far that has also been the Japanese experience.

So it may be that since we're only a few years into this period of very low rates, there may be some years to come, an occasional "overshoot" to yields below 2% is unimportant. After all, the stock market also used to have a roughly 3% yield floor, and then in the '90s, they got below 1.5% - followed by capital loss.

Also in favor of bonds, the Fed thinks that inflation is very, very low.

Courtesy of Doug Short, here's a chart of the trend of the Fed's favored inflation measure, the PCE, as well as the CPI:

Click to enlarge

Thus a 10-year tax-exempt bond yielding only 2% may even be giving a small positive return after inflation. And there are hints that inflation might just be dropping. One example comes from lumber. While the futures market for lumber is thinly-traded, Random Lengths shows this graph:

Random Lengths Framing Lumber Composite Graph

An associated chart for panels also shows a recent downtrend and had this dramatic commentary:

Random Lengths Panel Market Report:

Structural panel prices continued to retreat. OSB (oriented strand board: ed.) prices were in disarray as producers came to the market with varying sales strategies. Those with loads available for quick shipment sometimes sold block volumes at steep discounts. Southern Pine plywood prices continued to weaken in spotty trading. Inventories at the retail level were often down to the gravel, but buyers felt no inclination to alter their just-in-time purchasing strategies. Western Fir plywood prices fell as mills lowered quotes to keep inventories from piling up.

The above suggests that the housing boom may be pausing.

Fed funds have been moving lower, down to a mere 8 basis points. This pattern of a falling Fed funds rate and inflation fears was also seen in the spring of 2011. That time, of course, long yields came down sharply. Might the current drop in Fed funds rates also suggest that another major move lower in long-term interest rates is on the horizon sooner rather than later?

What would happen to stocks in 20 years if the 10-year T-bond traded at 6% then, and dividend yields equaled bond yields? Let's assume that as has been the case many times in the past, stocks traded at a 6% dividend yield at some point within a 20-year time span. To make it simple, let's assume that they hit that point in exactly 20 years. Right now, stock and bond yields are roughly equal, and they might stay that way. Where would stock prices be in a 6% world, one that imposes harm on bondholders?

To make a guess (one of many possible outcomes, of course), we can suggest that dividend payouts will rise at a compounded annual rate of 6% over the next 20 years, roughly their long-term average. (Note that corporate sales have only risen 4% annually for the past 20 years.) In that case, with the S&P yielding 2% now and the SPY yielding a bit less due to expenses, then 20 years from now, the stock market would be almost exactly where it is now. (That's because 6% compounded for 19 years triples.)

So it is possible that stocks could go nowhere in price until the 2030s, even with normal dividend growth. Of course, they would drop in price if Mr. Market demanded a 6% dividend yield within 10 years or less, even if dividends grew a little faster than 6% annually.

And of course, dividends are taxable. So stocks might return something on the order of the current 2% averaged with the theorized 6% to give an average taxable annual return of 4% -- for 20 years. If that's a reasonable thought, why should not most individual investors simply make an overweight allocation to intermediate-to-long-term tax-exempt bonds and ignore U.S. stocks? Munis have a variety of durations, forms, and quality, so investors can garner a variety of yields and duration exposure, as we all know.

A core advantage of tax-exempt securities is that they are expected to stay tax-free for most people, so investors always, they hope, have that working for them. All the rest of matters -- stocks versus bonds versus cash, etc. -- is supposition.

Where is public sentiment? Most of the investing public does not have a 1999 mentality about stocks, but many are hoping that stocks are the optimal asset class in these financially-challenged times. We all know what happened after the Y2K and 2007 market peaks. No matter what people know, it's what they (we) do that counts. And market participant behavior has signed onto the seemingly inexorable trend toward higher stock prices.

Surprisingly, though, given the obvious search for dividend income from common stocks, the public is showing its distaste for reasonably secure high tax-free yields. This is at least an orange flag if not a red flag.

To wit, there is a class of closed-end funds that essentially only is bought by retail investors, not institutions. These closed-end funds use leverage to buy more bonds. Being closed-end, as most readers know, they are actually stocks that can and do trade at varying premia or discounts to their asset value ("NAV"). The fund family that I'm most familiar with is Nuveen, and the investment revulsion that has recently occurred toward these funds is striking.

For example, Nuveen Select Quality Municipal Fund (NQS), a venerable one, closed Friday at a 10.9% discount to NAV. Clicking on the blue link on that web page gets one to a more detailed page that on the bottom left shows historical trading data for NQS relative to NAV. On December 3, 2012, it closed at $16.71 with a NAV probably a couple of percent below that, per Nuveen's data. From the same page, here's the swing to a large discount merely from half a year ago (Note this chart is not current through May 31):

Premium/Discount History1

As of 04/30/2013

Since Inception (03/21/1991)

Data reflects performance over the previous 12 months

NAV is down somewhat to $15.78 per the CEFA page linked to above, but the trading price has collapsed to $14.06. What has happened? First, the fund lowered its payout a bit and may well lower it a bit more, due to shrinking interest income. Second, Treasury bond rates have of course spiked.

The larger, also venerable Nuveen Municipal Opportunity Fund (NIO) shows a similar pattern:

Premium/Discount History1

As of 04/30/2013

Since Inception (03/21/1991)

Data reflects performance over the previous 12 months

But of course, the muni market is already priced to fully reflect rising long-term rates. The NAV of the bonds reflects their current dividend-paying ability. The public likely is simply chasing stocks and dumping bonds. Does the wise adviser and investor follow them?

I think not, at least not for very long.

This revulsion toward these types of income funds is occurring while no-dividend stocks such as Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN) are in strong uptrends near all-time highs (of course, Amazon is nearly profitless as well; part of a "New Normal" of highly valued non-profit investor-owned companies?). This is very much like the 1999-2000 psychology and market action. I hear over and over again from investors and traders in various locales that they are staying long and strong the market until they see 1999-type manic behavior toward stocks. But might that not be the 'hook'? Maybe we won't actually see actual mania, yet a top will form?

Conclusions regarding the above: Stocks have been trading at historically very high valuations for about 20 years, with brief periods of normal but not cheap valuations at the bottoms of the two major bear markets we're all familiar with. Thus it appears that they may have "used up" a good deal of future appreciation. A prolonged bear market for bonds may induce stagnation in stocks, given the high valuations of stocks similar to those of the mid-late 1960s.

Meanwhile, bonds simply are what they are. Inflation will be what it will be, and no one knows what that will amount to. In favor of bonds is the extraordinary swing from cyclically high valuations of certain closed-end bond funds to cyclically-low valuations, for which the retail investor is the usual purchaser.

Final thought re stocks: While the above discussion related to the SPY, it is after all a market of stocks. Some appear overvalued:

My opinion is that the zeal for small stocks, as exemplified by the Russell 2000 and its largest tracking ETF, the iShares Russell 2000 Index Fund (NYSEARCA:IWM), is excessive. From the Acting Man blog on April 29:

Click to enlarge
A new record high in speculative net long positions on Russell 2000 futures

It appears that since then, both futures on the Russell 2000 and the IWM ETF have had even more bullishness expressed.

Why is this occurring? The only thing these 2000 small stocks have in common is that they have not made a great success, if indeed they have made any.

It would appear that the most logical way to value the IWM tracking ETF is to subtract the losses from the loss-making companies from the aggregate profits from the profitable ones. That would appear to account for Blackrock's data that the P/E of the IWM was 26.91 as of 4/30/13. I have seen elsewhere that the 5-year earnings growth rate of the Russell 2000 is about 5.5%. Thus the P/E/G ratio is about 5:1. This may be something similar to that of the NASDAQ in its bubble phase, given much faster growth for the NASDAQ stocks back then.

As in the late '90s, too many investors or speculators may have joined in trend-following behavior.

However, many industry groups bottomed in March 2000 just as the NASDAQ and broad market were peaking, having often peaked in 1997 and 1998. Thus, today there is hope that individual names can be sound investments for the months and years ahead even if the broad market is poised for stagnation or a fall.

Careful research and attention to risk-reward metrics for specific equities should over time be rewarded by superior gains that over time exceed the returns from low-risk fixed-income investments.

However, because investors appear to be expecting more from ownership in shares in common stocks than I believe is reasonable to expect, even the best-thought out choices in individual equities may face important headwinds.

Summary: Nominal GDP growth has been slow, meaning that bond yields are sensible for the moment, though not really attractive. The stock market has outperformed the real economy for at least 20 years in a substantial way, and valuations were thought to be stretched in 1993. The public is chasing the Russell 2000 index (IWM ETF and futures) at relative values (PEG) similar to that seen with NASDAQ stocks in the late 1990s. Just as the bursting of the NASDAQ bubble was associated with interest rates that were thought to be impossibly low, so might a renewed cyclical downturn in the U.S. economy solidify a more prolonged period of extraordinarily low interest rates.

Disclosure: I am long NQS, NIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not an investment adviser. Nothing herein constitutes investment advice.