The massive bond bear market means that bonds already provide some real competition to stocks. If the U.S. market moves to a 13% haircut from the recent peak, dividend yields either on the SPDR S&P 500 ETF (NYSEARCA:SPY), or the iShares Russell 2000 ETF (NYSEARCA:IWM) (P/E 27, dividend yield 1.7%), will remain low. Therefore, unless this bond bear market reverses, an investor who begins to get anxious would be able to look at A-rated tax-exempt 10 year municipal bonds yielding (say) 3% and say, I'll switch. Get me out: preserve my profits or cut my losses.
The basic problem with the U.S. stock market has nothing much to do with the quality of the assets. Most large-cap U.S. businesses appear to be well-run and well-financed. It is just that a growing number of valuation metrics are quite elevated. I recently wrote an article on Seeking Alpha about two different Value Line metrics that both suggest that much lower stock prices would be reasonable possibilities. Jeremy Grantham of GMO, who is well-known for previous successful multi-year relative valuation inter-asset calls, updated his valuation metrics recently, as of the end of May. His expectation for U.S. large cap stocks was that in 7 years, their total return would be roughly zero. John Hussman has been saying for some time that his stock models are similar to Mr. Grantham's.
Models are only models, but there are several metrics pointing in a similar direction. The Wilshire 5000 Total Market Index closed Friday at 16,789 - roughly equal to 1X GDP. Before the late '90s, the U.S. market had never risen above about 85% of GDP (if memory serves), which occurred at the peak in 1929. Similarly, the dividend yield on the S&P 500 or its equivalent essentially never went below 3% until 1993. Since then, except for brief bear market bottoms, it has never ascended above that level.
Why will those parameters not normalize, finally? Would it be a bad thing if they did? Isn't it a good thing when shares in corporations provide high and reliable dividend yields, say in the 4-5% range?
Demographics are working against stocks at current yield levels. Every Boomer I know, including myself, understands that either he or she is rich, or not, and that's that. The few who are rich mostly don't expect to get richer, and the great majority who are not have as their main interest not losing what they have. That's a constant drag on share prices taking off.
What we/they want for the future is stability of principal and some reasonable expectation, or at least hope that the dividend or interest rate will keep up with inflation. The thought of trying to strike it rich by participating in yet another asset inflation is looked at askance. Been there, done that. We don't care if others want to play that same game, but just don't break the economy again doing it, OK?
As the Cole Porter song goes, it was fun, but it was just one of those things. And too many people have a hangover.
Those such as ECRI (the new name for the Economic Cycle Research Institute) who are thinking that a 1928-9 stock market price inflation is a strong possibility may be correct, but I think that too many people who have assets are unlikely to chase stocks up if the nonsense that went on in the late '90s reappears. If it does, so be it.
A trend is reversing. In the 1950s, most insurance companies or pension fund managers looked with horror at the idea that any such funds would go into stocks. So they went into "safe" bonds, which a few decades later would become known as certificates of confiscation. Interest rates that are looking better will make it easier to continue the recent trend of reallocating back toward bonds. Only with bonds can a defined benefits pension plan make promises it can keep, given it makes no representation about the buying power of those bonds when the retiree starts getting paid.
The two main theoretical supports of this bull market are both sliding rapidly out from under stocks. Stocks were represented as one-decision income vehicles as well as inflation hedge assets, but suddenly they are not great relative income vehicles, and commodity inflation and global stock markets are diminishing the desire to hedge against inflation.
My multi-year expectation has been that elevated stock market valuations by historical standards have been likely to normalize at some point in the future. Perhaps this process is going to actually start and continue, as it appeared to do after the Lehman debacle.
When I don't like the odds, I seriously cut stock allocations and expect to be out of the market before the final top. I really, really like to own shares in American businesses, but I also like to support municipalities by lending them money in return for tax-exempt income; right now I like the prospective returns on the latter better when adjusted for safety given the surge upward in interest rates. (In part this is because American businesses are heavily exposed to non-U.S. economies, which I think are generally weaker than the U.S. economy is.)
On a current and trending basis, interest rate surges are destroying nominal financial wealth as bond prices crater; commodities prices are dropping, also destroying financial wealth; emerging stock and bond markets are dropping, further destroying nominal wealth; and Greece and Cyprus are back in the headlines of the financial press. Why will global investors not at the very least salvage what is turning into quite a bad year by taking profits in U.S. shares? Why will they not look at relative global market P/E's and rebalance toward cheaper markets that may also offer faster prospective growth rates?
Are we seeing a remake of a movie we have seen before, and that ends unhappily (although a sequel ends well)?
To switch analogies, there are a number of summer storm clouds gathering, and it may rain; if it rains it may storm. If it storms, first-quality equities may undergo an important (temporary, presumably) markdown. If so, cash today will not look like trash tomorrow.
It may be approaching a time for active asset allocators to decide whether to engage in any precautionary selling of U.S. equities.
For yours truly, a "better safe than sorry" attitude toward equities has supervened. Price changes in bonds that can be held to maturity mean little, especially as deflationary pressures mount, but somehow I think that stocks are different. So I'm keeping elevated cash reserves and gradually buying munis into this strange, vicious bond bear market.
Additional disclosure: Not investment advice; I am not an investment adviser.