It is disputed in a few corners, but more analysts and strategists view bonds as severely overvalued and stocks as symmetrically cheap. We share this judgment and point to assorted different ways to reach this conclusion. Investors should be trying to inoculate their bonds holdings from losing value at some point and taking advantage of the upside potential in equities. The “lost decade” in stocks could easily be followed by a lost decade in bonds, while stocks recover.
Companies issued few bonds in May and early June during the Greek credit crisis. Since then, companies have been issuing record amounts of new debt at ever lower interest rates that is very telling about the bubble in bonds. This past week, McDonald's (NYSE:MCD) sold $450 million in new 10-year notes at a yield of 3.5%, a mere 30 basis points above the 3.2% paid on its common stock, despite the company’s history of sizeable dividend increases over the past several years. The McDonald's issue to too large to dismiss, but if more convincing is needed, Kimberly Clark (NYSE:KMB), a slower growing company and the maker of such staples as Huggies and Kleenex, recently sold 10-year bonds at 3.62%, compared to a yield of 4.1% on its common stock. The implicit message is that many investors prefer the known low yield on these high quality bonds to the uncertain and more volatile growth of the company’s common stock dividends. This near equality of bond to dividend yields reflect investors' fears that the recovery will lapse into a double dip recession, that tax rates will rise, or that policymakers just don’t have things under control. Are these fears warranted?
Stock yields commonly exceeded bond yields after World War Two, as investors worried that the economy would relapse into depression without the stimulus of government war spending. So, investors required a high dividend yield to be willing to risk buying stocks that could plunge in value. Instead, stocks went on a multi-decade growth spree that provided equity investors with huge returns, while investors who bought into “safe” bonds were devastated, as inflation exceeded their low bond yields.
Predicting the timing when stocks will next take off and bonds get hurt is extremely difficult. What is not difficult is judging their relative value. The market’s price earnings multiple of less than 12 based on 2011 earnings estimates, which analysts are raising in response to upward guidance, is extremely low, especially when compared to other historical periods when interest rates and inflation were both low. Today’s appropriate price earnings multiple ought to be well above 15 and possibly as high as 20, suggesting that stock prices ought to be higher by 30% to 70%.
As usual, investors are reacting on the basis of recent market behavior and doing so without long-term historical context. So they are shunning stocks, because of the dismal 10 year performance, and pouring money into bonds, because of the good performance there, despite exceptionally low prevailing interest rates. And as usual, investors are fighting the wrong war. Interestingly, in a recently published article, Bloomberg reported that institutions, including mutual funds, pensions, and endowments are exceptionally bullish, while retail investors are not and the disparity is the widest since March 2009. That’s also when the stock market bottomed after the credit crisis. Shockingly perhaps, even Bill Gross, manager of the world’s largest bond fund, is bullish on stocks and thinks bonds have seen their best days. (But, he thinks you should buy his bond fund anyway.)
It is fair to ask whether there are any circumstances under which investors might be behaving properly. Of course, there must be such a scenario. Investors must believe that the economy will perform very poorly, so that ownership interests in companies will provide meager or very poor returns. This scenario requires another decline in GDP, a further or renewed rise in unemployment, and disappointing corporate profits. Such a scenario is possible, but highly unlikely, at least in my judgment. But the risk of such an economic environment is already reflected in prevailing stock prices. So to do badly in stocks from current levels implies that the economy perform even worse than expected. I don’t need to be wildly optimistic to think this scenario is more a reflection of prevailing fear than a realistic judgment regarding the economy’s future.
Disclosure: No positions