"Two-Year Bund yields turn negative" - Reuters
Headlines like that help explain what happened to equity prices in May. The earning and dividend yields on stocks rose and the yield on bonds fell. When German bond investors agree to lose a fixed amount of money1, rather than buying any other asset with a potential for gain, we're dealing with an extreme amount of fear.
And fear (and greed) are the two emotions that get investors into trouble.
Academic theories about investment selection typically revolve around the idea of "expected returns" and "risk". In the real world, there are a number of other factors that drive the decisions. Some of these have a major influence on the bond market.
First of all, there is manufactured demand. Many insurance companies are legally required to own bonds and many pension plans buy them not because of a regulatory requirement but because the law considers it "prudent" for a trustee to allocate pension fund assets to bonds. But most of all, banks that lend money to governments (by purchasing bonds) are permitted to have more assets (i.e.. more leverage) than banks that lend money to companies.2 This is one of the principles of the harmonized bank regulation known as the Basel Accords.
Back in the 1970's, some conservative economists warned that increasing levels of public debt would "crowd out" private borrowers from the market. The thinking (almost quaint in hindsight) was that there was a fixed amount of money that could be borrowed and it could either go to businesses (which would presumably spend the money wisely) or to governments (which would presumably spend the money foolishly).
Apparently, there is not a 'fixed amount of money that can be borrowed'. But the rules now steer banks towards lending it to governments. Business loans in the US fell from a peak of $1.6 trillion in 2008 to $1.4 trillion today. Over the same period, US banks increased their holdings of US government bonds from $1.2 to $3.1 trillion3.
Of course all of this money flowing into bonds has driven up bond prices and when you consider that in the futures market, a stock futures trader can buy or sell about $15 of equity market value for each $1 of capital while a bond futures trader can control about $65 worth of bonds for each $1 of his capital, the reason for the sluggish performance of stocks becomes even more understandable.
So in this type of environment, what is the best course of action?
- Sell equities and buy bonds?
- Go to cash?
- Stay in equities?
With interest rates as low as they are right now, lending money to governments doesn't seem like a prudent investment. A 1% increase in interest rates - (back to the levels of August 2011) would cause 10-year Treasuries to lose about 9% of their value. It will take over seven years for a bondholder to break even from coupon clipping - assuming rates don't increase even more.
Going to cash has the reassuring quality of eliminating day-to-day price volatility as a source of anxiety, but it comes at a cost: the opportunity cost of staying in cash earning zero interest while stocks are paying dividends and companies are posting record profits.
And those record profits are what keep us excited about owning equities. The earnings per share of the S&P 500 is forecast to grow about 10% over the next 12 months. (The stocks we own have an expected growth rate of about 19%.) And of course, you get dividends. But you also get the volatility. There is no free lunch.
The ratio of bond yields to dividend yields is as low today as it was during the middle of the 2008 financial crisis. At these levels, there is an arbitrage opportunity - short term borrowing costs are lower than portfolio dividend income.
This doesn't mean that stock price volatility will go away. The combination of perceived political risk from Europe and Washington and high-frequency trading will remain, but as the bubble in bond prices begins to pop and investors start looking for value, owning growing, profitable dividend- paying companies will be a profitable strategy.
1 Incidentally, the bonds were denominated in euros.
2 Owning a portfolio of bonds also reduces operating costs for banks as commercial loans require thousands of employees to make credit decisions and administer and collect the loans while a multi-billion dollar bond portfolio can be managed by a handful of employees.
3 Source: Federal Reserve of St. Louis