Why I'm Holding On To My Bonds

Includes: AGG, IEF, SPY, TLT
by: Sameer Advani

The flavor of the day is to sell bonds, buy stocks. Really? Let's see what's the bearish case for bonds. Interest rates were recently at all time lows and can only go one way, the Fed may reduce the pace and quantity of bond purchase this year, the overnight rate may or may not be hiked sometime in 2015 or 2016 from zero, bond vigilantes may or may not drive up the yield curve too far and force the Fed to raise rates early. Really?

So I should sell my current under allocation to bonds (~20%), and load up on more stocks when the S&P 500 is trading at 16x trailing earnings, 2.5x price to book, and 1.5x price to sales. Really? Revenues and earnings growth for SPY are flatlining and projections are being revised downwards, global GDP is growing at 3% or less, inflation is falling worldwide, governments in Europe, America and China are reducing investments in physical capital, and Japan is doing hara-kiri with its financial system. Margin debt is at an all time high and hedge fund long positions are at the highest level since 2007. Investment banks are out ringing bells and bringing the sheep to slaughter with enticing price targets of 1700 and 1800. Nobody thinks stock prices can ever fall substantially again. Really?

When the facts change, I change my mind. I had a previous call of 1800 to 2000 on the SPY in two to three years. Now I'm not so sanguine, and here's why.

The current risk/reward ratio for equities is neutral to unattractive. It was relatively easy (and contrarian) to buy equities in 2011 and 2012, when the market was trading at 13 and 14x earnings, respectively, and earnings were growing at 10% on average. Now with growth in EPS likely to fall to around 5%, revenue growth stalling, and the PE expanding to 16, it's not as easy to say "buy equities".

The SPY is getting priced to perfection, at the same time that we are closer to the next recession than the last, and EPS growth drivers are lacking. The borrow/buyback game has been played and cost cutting has reached its nadir. The recent dollar strength is sapping demand for US produced goods in favor of U.K., EU, Japan, Korea, China, and most all other countries who are continuing to debase their currencies. With over 30% of the SPY revenues coming from overseas, this will not be just a "minor" impact on EPS growth.

Consumer confidence is up. That's a good thing. Auto and home sales are brisk, home prices are up smartly. However, consumers are fickle minded and feel great that stock prices and house prices have risen on the back of waves of central bank money. This doesn't mean they will go out and increase discretionary spending like they did in years past.

Look at what they do, not at what they say.

Total household credit continued to contract in the first quarter at -0.6% annualized, with contraction in home mortgages outstripping increases in revolving, auto and student loans. Household debt to GDP is at 82%, below its peak of 98% in 2007, but well above the 1980-2000 average of 60%. Debt servicing costs are low, thanks to Uncle Ben, and are likely to stay that way ... thanks to Uncle Ben. This doesn't mean households will re-lever any time soon. The de-leveraging cycle still has a ways to run. At the current pace of de-leveraging, household debt won't reach 60% of GDP until 2019. Assuming we have nominal GDP growth of 6% annually between now and then, which was the average nominal GDP growth from 1980 to today (an unlikely assumption but generous), household credit would grow at an average rate of 1.5% between now and 2019. To put this in perspective, household credit grew at an average annual rate of 9% for the 25 years preceding the great recession.

Households are not the only entities that are still de-leveraging. State and local governments have several more years of treading water to reach sustainable debt levels. The financial sector also has a ways to go. Total financial sector debt peaked at 120% of GDP in 2008. From 1980 to 2000, financial sector debt averaged 44%. However, this sector is de-leveraging much faster than households, and if the current pace continues, will reach 65% of GDP in 2015.

Credit is the lifeblood of economic growth. Unfortunately, much of the credit consumed over the last 30 years has not added sufficiently to the physical stock of the nation. Falling interest rates and financial deregulation have allowed ever increasing borrowings. This dynamic shifted in 2008, and it has been, and will continue to be, a long, slow trek to get back to a sustainable level of leverage and growth.

Which is why, with all of the fuss over the recent short term rise in interest rates, the economy cannot handle a sustainable rise in rates yet. Maybe by 2015/2016, de-leveraging will be winding down, and rates can rise, but now is not the time. The Fed did a marvelous job in pricking the asset bubble in high-yield sectors by threatening to raise rates. Whether the "taper" happens or not is irrelevant. The flow of government bonds is set to slow dramatically over the next few years, which is yet another drag on economic growth. If the Fed tapers its purchases of bonds, it will not change the dynamic in the market sufficiently to warrant a significant steepening of the yield curve.

To put the yield curve in perspective, over the last 54 years, the spread between the federal funds rate and the 10-year treasury has averaged 0.9%. It is currently at 2.6%. In the years which the spread has been positive, it has averaged 1.77%. In 7 out of the last 54 years, the spread been wider than it is today. In only 2 of those years, (1977 and 1004), traders were successful in front-running the Fed. The spread will likely contract, as banks have nowhere else to put their reserves to work until the de-leveraging cycle winds down.

With inflation trending at under 2% and real GDP likely to grow in the 2% range, there is not a huge downside to bonds. However, the downside to equities is significantly higher. Therefore, I believe that high quality, medium duration bonds still have a place in a well balanced, diversified portfolio. Because we cannot predict the future, it would be foolhardy to sell your bonds now and plow into equities. There will be other major drawdowns in equities in years to come, which is as predictable as death and taxes.

Of course, I could be wrong. Real GDP growth of 5% could be right around the corner. Global commodity prices may surge again causing a wage-price inflation spiral. Consumers may ramp up borrowing against the values of their 401Ks and houses, incomes may grow at 4% to 5% and employment may drop back to 5%, so that everyone who wants a full-time job with benefits can find one.

Magic pixie dust could also sprinkle down from the heavens and cause all natural disasters to stop, wipe out infectious diseases, and bring an end to poverty. Wouldn't that be nice?

Disclosure: I am long SPY, LQD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.