Who's Got It Right: Bullish Stock or Bond Investors?

 |  Includes: AGG, DIA, QQQ, SPY
by: Yale Bock

Lewis Black is an hysterically funny comedian, which is special, but even more unique is his use of extremes. If you have ever watched a set of his, he has a routine where the punch line of the joke ends with Black screaming, "We're BLEEPED, We're Bleeped. (screwed but with an "f")." In looking at the stock and bond markets in the current environment, it seems that every piece of macroeconomic information released should make us rename the U.S. economy the "We're BLEEPED" market.

To be fair, there have been data which support the idea that the economy is significantly weakening. For example, last week unemployment claims went above the 500 thousand totals, while this week they settled at 470 thousand. In addition, new and existing home sales both revealed a 30% reduction in sales, the worst number in 15 years. On Friday (August 27

Naturally, the stock market has reacted unfavorably to these events, closing down in each of the last three weeks. So, these events and the decidedly negative attitude in the market lead to the key question: Which type of investor is accurately forecasting the direction of the economy, bullish stock investors or those who favor the bond market as a superior investment alternative?

Bond investors believe deflation will continue to be the main threat to the U.S. economy and bonds will preserve capital better in a negative, low, or no inflation rate scenario. On any asset, the real return is the nominal rate of return minus the rate of inflation. For example, if inflation is zero or close to zero, and an asset yields a nominal rate of 2%, the real return is 2% (R=2-0=2%). With two year treasury bonds at .56% (a little more than half of 1%), 10 year bonds at 2.64%, and the 30 year yielding 3.67%, current prices have very little margin of error in the event inflation picks up. Consider the following quote by Michael Lewitt, president of asset manager Harch Capital Management in an interview with Lawrence Strauss in the August 30 issue of Barron's:

Barron's: What's ahead for Treasuries?

Lewitt: When the yield is below 2.50%, it doesn't take much of either an inflation scare or something else—but it would most likely be an inflation scare to make rates rise (interest rates). And as they rise from such low levels, the mathematics are just brutal, and you can get your clock cleaned by going long Treasuries or high grade bonds. So you have to be very, very careful. If you buy a bond and you are going to hold it to maturity, you are locked in at around 2.5% now for 10 years. It's an awfully long time. I don‟t think rates are going to be appreciably higher for quite a long time, either. So it is prudent, for a little more yield to go into, say, an investment grade bond fund. But you may have some price volatility when that backup (of rates) comes. I am of the school that believes that deflation is a bigger risk than inflation, and that inflation is not going to come for a while. Right now the black- swan trade is betting on inflation. Everybody seems to be betting on deflation and lower rates, so the outlier trade is that there will be an inflation scare and that low rates will pop up- and that could really decimate some portfolios.

For the last quarter, the GDP came in at a revised 1.7% growth, down from the previous quarter of 3.6% growth. Some economists had forecasted growth to come in at .5%. As Art Cashin, long time trader on Wall Street, said on CNBC, "There is a bull market in pessimism." Throwing in his two cents was famed economist Nouriel Roubini, who upped his forecast of a double dip recession to 40%.

Stock investors, including myself, point to many factors as to why stocks are currently a good value. First, valuations are cheap with many large cap stocks in the S&P 500 trading at 10-12X forward earnings. Second, dividend yields on high quality stocks range anywhere from 2.5-4%, in many cases greater than the longest of bond yields. Third, corporate earnings have been strong and the amount of cash sitting on balance sheets is at an all time high. Fourth, companies can borrow at low rates to fund operations or engage in merger and acquisition activities. If companies can grow operating cash flow at anywhere from 5-10% per year, based on the previous factors, it is hard to see how stocks are not a much superior investment alternative than bonds, but again, I am always biased towards stocks.

Finally, in the investment world there are many choices out there, but investors are forced to live with the choices about allocating capital. I believe the most dangerous threat to the U.S. economy is the possibility the deflationist camp is wrong and there is a massive bond bubble waiting to be pricked by higher inflation or interest rates. Billions of dollars have been pouring into bond funds over the last 18 months, and the bond market has been in bull mode for 15 years. The world must have deflation for a long time for the bond thesis to hold up. If it does not turn out to be accurate, bond investors must live with the outcome, both good and bad.

Global Economic & Financial Markets Outlook

(All country index data provided by the market data section of the WSJ on August 28, 2010)

The majority of international stock indexes throughout the world had negative returns through the end of August 2010. As far as specific continents throughout the world are concerned, the consensus view in the investment community regarding economic outlooks remains the same- the mature economies of Western Europe, other than Germany, will struggle under various austerity measures to deleverage and the result will be flat to minimal growth over the next few years. Asian economies and the BRIC countries should continue to have the quickest GDP growth in the world, but that does not mean their financial markets will outperform every year.

As far as global capital markets are concerned, there is a unique situation which currently exists. The BRIC countries, which many investors consider the place where a heavy percentage of their assets should be allocated, have not performed well this year as far as investment returns are concerned. Last year, those indexes dramatically outperformed other world indexes. For example, the Bovespa Index of Brazil is down -4.4% year to date, the Russian RTS Index is down -0.3%, India's Bombay Index is up +3.3%, and China's Shanghai composite and the Dow Jones China 88 are down -20.3% and 23.9% respectively. These data speak to time horizon as a key factor in considering potential investments because the more time an investor has, the better chance a BRIC investor will see better than average returns. In that vein, now might be an excellent time to consider specific BRIC country indexes for a potential investment.

Finally, I think it is always important to look for countries which have notably outperformed through the year. Interestingly enough, Turkey's index is up 12.3% for the year, Thailand has increased 22.6%, the Philippines have grown by 16.6%, and Indonesia's return is outstanding at +22.5%. All are excellent returns for country indexes in a very tough environment for positive returns. However, as the BRIC country index returns show, one year of returns is too short a timeframe to make assertions about outperformance for a great length of time.

Disclosure: No Positions