One seer says stocks will have short-term rallies as bonds succumb to a major bear market. But long-term investors, beware.
MEMORIES OF THE 1970S AREN'T PLEASANT for the most part. Watergate. Defeat in Vietnam. Leisure suits. Granny dresses. Disco. And most importantly, the emergence of stagflation, with inflation and unemployment soaring in what seemed then to be the Dickensian worst of times.
What's forgotten is that the second half of that benighted decade wasn't bad for equity investors. After the devastating bear market of 1973-74, stocks actually scored decent rallies through the rest of the decade. And that was in the face of a collapsing bond market bought on by the soaring inflation and the collapse of the dollar.
Notwithstanding the current focus on deflation, CLSA strategist Russell Napier, thinks markets will experience something more like the inflationary 'Seventies. Bonds are face a major bear market while equities should see major rallies—even if the ultimate lows in real, inflation-adjusted terms still lie ahead.
For equity investors, valuations have gotten so depressed that they all but guarantee strong returns, he says. Dividend yields are the highest relative to government bond yields since 1955, according to Napier. Since 1958, when stocks began to yield less than bonds, high stock yields relative to bonds consistently have meant strong equity returns.
Moreover, he adds, the relative valuations of stocks versus bonds suggest markets are discounting a decline of more than 60% in corporate profits. Absent such an eventuality in a double-dip recession, stocks are priced for a too pessimistic future, Napier contends.
Indeed, in a research report entitled "It's not the economy, stupid," equities ought to do substantially better than what's implied by gross domestic product or employment data. Valuations count more, and they're so depressed that anything short of a new downturn implies vastly better returns from stocks that bonds.
Of course, just the opposite has been true in 2010. For instance, the S&P 500 SPDR exchange-traded fund (SPY) has returned 6.21% since the beginning of the year, according to fund-tracker Morningstar, which is less than one-third what the longest-duration Treasury ETF, the Pimco 25+ Year Zero Coupon U.S. Treasury Fund (ZROZ) scored so far in 2010, 19.34%.
In other words, this year the correct decision has been to buy bonds for capital gains and stocks for income. That has been a profound reversal of fortune.
And it is one that favors stocks over bonds, Napier contends. The deflationary outcome discounted by the markets is made less likely by a number of factors. Money and credit no longer are contracting. Corporate cash is likely to be mobilized for expansion or acquisitions instead of bolstering balance sheets.
Bonds, Napier further contends, are about to enter a bear market "that will last a generation." With yields starting at such a low level, with the 10-year Treasury around 2.50%, any substantial rise in yields will result in price declines and negative total returns.
But the early stages of a bond bear market aren't a barrier to equity returns, as the record of the late 1970s showed. Indeed, Napier doesn't see stocks being threatened until the benchmark 10-year Treasury reaches 5%.
Even so, he points out that the real, inflation-adjusted low in stocks wasn't reached until 1982. Which should give investors pause. Indeed, Napier contends that valuations aren't down far enough to give investors confidence to buy and hold stocks for the long term.
To be sure, stocks are cheap relative to bonds. For fixed-income portfolios, there are more basis points in yield on the upside than downside.
Whether investors will act on this is another question. Corporate pension funds have moved heavily into bonds, for instance.
Cheap stocks also can remain cheap for a long time. Bonds and bond funds face significant losses if yields rise. So what's the answer? Napier's research suggests fixed-income investors should shift a portion to stocks, and vice versa.
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