Discussions about a bond market bubble have been all the rage as of late. Historically low yields are frequently cited as evidence that the bond markets are in a bubble. Another often cited argument, specific to government bonds, is that the supply of bonds keeps growing and eventually investors will reject purchasing this paper at such low yields – which will force yields higher and investors who previously bought into the market will get burned. A third argument is that inflation will likely increase over the coming years which will, in terms of real dollars, lead to losses for bond investors. Most people in this camp tend to argue that this bond bubble will end in tears for investors who piled in during the last stages of this bubble.
While these arguments might represent a compelling case to avoid fixed income investments (particularly government bonds), there is another group of investors, bankers, and asset managers who extend the argument to suggest that stocks are the superior investment because bonds are, in fact, in a bubble with historically low yields. Typically this argument utilizes a tool referred to as the “Fed Model” which essentially argues that when the earnings yield on equities is greater than the yield on long term bonds, then investors should shift more of their assets into stocks. Based on my back of the envelop calculations, the current S&P 500 earnings yield is approximately 7% – easily above the yields on a 10 year government bond under 3%. Thus, stocks must be cheap. Not so fast! Wait just a minute...
There is a problem with this logic. If bonds are in a bubble that is purportedly going to end in tears for the poor souls who pile in at historically low interest rates, then the natural implication to conclude is that companies, as well as the government, will be challenged to make payments on these obligations in the future, right? Well if that is true, then it must naturally follow that earnings are going to fall in the future (e.g. earnings will not be high enough for companies to service their debt). While, there is potentially some opportunity cost for an investor who buys a 10 year bond only for interest rates to rise a few percentage points such that the investor will realize a yield less than what would have otherwise occurred. But, this does not constitute a serious burn. Assuming the company can service the debt, investors won’t exactly get burned – rather these investors make just a little less.
However, if it turns out that companies and governments do face challenges servicing this debt in the future, stocks are by no means cheap anyways. On the contrary, within the context of risk, under this logic stocks are expensive. Afterall, the implication is that earnings are falling.
What should investors conclude from this? Bonds could potentially be in a bubble. But that fact does not imply that stocks are cheap in the context of risk. On the contrary if bonds are in a true bubble that will necessarily come crashing down (in a similar fashion to technology stocks in the dot com bubble) then stocks are inherently expensive/risky currently. Is this confusing and hard to reconcile? Good. It should be. This is precisely why the macro financial risks are so substantial that realizing average returns will be increasingly difficult going forward (as argued by PIMCO a few weeks ago). Large cash positions, short term investments, or SMALL positions risky investments make for a superior investment strategy in this sort of situation. Why take a HUGE bet in such a risky time? Why not wait for at least some of the risk to be reduced. Perhaps this November a great deal of politically induced macro financial risk will come off the table.
Disclosure: No positions