It is a question that I have received frequently from commenters on Seeking Alpha in recent weeks. With yields already at record lows and interest rates almost certain to go nowhere but up in the future, why in the world would you want to own high-quality bonds like U.S. Treasuries today? This is an outstanding question that is worth closer consideration.
The Same Could Be Said For Stocks
What I find particularly interesting about this great question is the context. Indeed, Treasury yields are already at historical lows, and they can only go so much lower before they run into the zero bound. Moreover, Treasuries along with bonds (NYSEARCA:AGG) in general are undoubtedly expensive in the current market environment. So why would anyone want to commit their capital for as many as 10 years or longer until maturity in buying bonds that are already expensive and pay such paltry yields?
The immediate response to this question, however, is that the exact same thing could be said about stocks (NYSEARCA:SPY) in the current market environment. Once again, stocks are currently trading at historically high premiums that can only go so much higher before they start to lose altitude. Viewed in the inverse to make a better apples-to-apples comparison between stocks and bonds, stocks are currently trading at historically low earnings yields (E/P, or the inverse of the P/E ratio) that can only go so much lower before they also run into the zero bound. So in keeping with the thinking that many associated with the bond market, why would anyone want to commit their capital in perpetuity (for unlike bonds, stocks do not reach maturity at some predetermined future date) in buying stocks that are already expensive and pay such paltry earnings yields?
In short and setting aside for now the various other specialized asset classes that are doing their own thing, investors are presented with a choice in today's market environment. They can either buy expensive stocks, or they can buy expensive bonds.
But let's return to some of the key points raised in the comparison above. First, just wait a second. Who said that I was going to hold stocks for perpetuity? After all, I trade in and out of stock positions all of the time on any given trading day, so what is this holding stocks forever nonsense? To this question, I would absolutely agree, as this thinking is completely correct. Investors seek to purchase stocks at attractive prices and sell once their upside targets have been reached. And this can be done over the course of a trading day, a month, a year or maybe several years depending on the stock. Absolutely right on.
But what is often overlooked about bonds including Treasuries is that an investor can do the exact same thing. Sure, one can purchase a bond with the objective of holding to maturity and collecting the coupon payments all along the way. But the returns generated from a bond come not only from the coupon component, but also the price component. And the longer the duration until maturity for a bond, the greater price volatility both to the upside and downside that an investor can expect to experience at any given point in time. Moreover, the advent of exchange traded funds such as the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) or the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) provide investors with the liquidity to move in and out of these Treasury allocations just like a stock and without having to wait for your broker to hunt down a price quote and execute the trade for you with its associated hefty commissions. One has to look no further than the price chart on the TLT to see how bonds can look a lot like stocks.
In short, just as I don't intend to hold onto a stock for perpetuity in most cases, I also don't intend to hold onto my bond allocation for the next few decades until maturity in most cases either. Instead, I am buying and selling my Treasury allocation at any given point in time the same way that I am managing my stock allocations.
So why do I favor bonds over stocks in the current market environment? After all, both are very expensive by historical standards, and both run the risk of getting beat up pretty badly to the downside at some point in the future before it's all said and done.
My reasons for favoring bonds over stocks is the following:
First, I know that global central banks are determined to remain highly accommodative with their monetary policy for the foreseeable future. Yeah, the U.S. Federal Reserve talked last December about how it wanted to raise interest rates four times in 2016 as it works to normalize interest rates, but the events since have shown that this is nothing more than talk. So it's not surprising to hear some tough monetary talk from time to time, and the Fed might be able to squeeze in a quarter point hike here and there. But global policy makers remain far too skittish to begin tightening in earnest any time soon. Such a policy environment is supportive for both stocks and bonds.
Second, it is worthwhile to consider the reason why monetary policy makers remain so unbelievably accommodative. After all, they continue to push the boundaries of what are extraordinary measures when it comes to creative policy initiatives. The reason is that global economic growth is stagnant at best and teetering on the brink of a full blown deflationary spiral at worst. Sure, we can talk all we want about how the latest monthly employment numbers were solid and progress is being made in getting the core inflation rate higher. But it is always important to keep in mind that these supposedly cheery economic headlines are coming against a backdrop where global central banks are effectively printing money hand over fist and giving it away. From my perspective, the fact that we have seen such persistently sluggish growth despite the fact that global central bank printing presses have been running hot for nearly a decade now is a testament to the profound and chronic weakness of the global economy. If the global economy is weak, corporate earnings are facing an increasing headwind that no amount of cost cutting, low cost debt issuance, or share buybacks will be able to cure in the end. Such an economic environment is negative for stocks but supportive of bonds.
Lastly, while both stocks and bonds are expensive from an absolute perspective, stocks are also expensive from a relative perspective while bonds are inexpensive in this regard. These points are particularly true of U.S. stocks and U.S. Treasuries. For U.S. stocks, they are current trading at more than 25 times earnings, which is much more expensive than what is currently on offer from the rest of the developed world at just over 15 times earnings and the emerging world at just 11 times earnings. Conversely for U.S. Treasuries, bond yields in places such as Germany (NYSEARCA:EWG), Switzerland (NYSEARCA:EWL) and Japan (NYSEARCA:EWJ) already well into the negative far out the yield curve. They are also lower in economies as challenged as the United Kingdom (NYSEARCA:EWU), Italy (NYSEARCA:EWI) and Spain (NYSEARCA:EWP). Thus, U.S. Treasury yields still have a long way that they could drop (and consequently U.S. Treasury prices could rise) before they even start to catch up with the rest of the world.
"Can't We Have Both?"
I'm with Shelly Chee Chee Hall on this point, as this is timeless investment advice for true portfolio diversification.
Just because I favor Treasuries over stocks does not mean that I only own Treasuries and do not own stocks. Instead, I own a healthy serving of both. And given the general price strength of both over time coupled with the negative returns correlation that exists between the two categories, this has been an advantageous approach throughout the financial crisis and the years that have followed, even if stocks have slowed Treasuries down over the years.
And just because one is bearish on the stock market as a whole does not mean that one has to throw overboard all of the individual stocks that make up the market. Because I am bearish on stocks in general, it implies the need to favor more defensive allocations over their cyclical counterparts, not abandon the stock market altogether. More specifically, owning shares of an inferior goods titan like Wal-Mart (NYSE:WMT), a well-established defensive electricity giant like Southern Company (NYSE:SO) or a more specialized niche offering like Community Bank System (NYSE:CBU) can lead to an entirely different returns experience than what the overall broader market may have to offer at any given point in time.
In short, just because one is bearish on stocks does not mean that one does not own stocks. Instead, bearishness dictates the types of stocks one is likely to own at any given point in time just as bullishness does the same.
The Bottom Line
Bonds are expensive. But so are stocks. And given the choice between the two, I favor bonds over stocks. For while U.S. stocks are absolutely and relatively expensive with fundamental headwinds, U.S. Treasuries are absolutely expensive but relatively inexpensive with fundamental tailwinds. But despite favoring bonds over stocks, I own both. And the key with either the bond or stock allocation is the security selection within each category that best fits the economic and market backdrop at any given point in time. In short, it's all about staying balanced at the end of the day.
For those that may be interested in working to balance the scales between stocks, bonds and a variety of other asset classes, this is one of the things that we do on an ongoing basis on my Seeking Alpha premium service known as The Universal. Please join us or send me a message if you're interested in learning more.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am/we are long CBU,WMT,SO,DXJ,TLT,IEF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.