Tuesday, 10 January 2012

Stocks vs Bonds: Bonds Win Every Time

In the US, stocks prices are moving firmly higher - the S&P 500 is trading at 1,290 points or so, which is up a nice 25% from the levels at the start of 2010 and up 85% from the March 2009 low - at the depths of the Crisis when many good people thought the world was being catapulted towards depression.

In isolation, a rising stocks market only occurs when there is an upturn in the economy and a feeling that a good rate of economic growth will be sustained.  This makes sense.  When an economy is growing at a solid pace, firms make solid profits, they employ more staff, meet their debt obligations and as a result, share prices move higher.  It is beautifully simple.  Of course, the reverse happens when an economy is weak, let alone in recession.

The stock market is saying that the US economy is kicking off 2012 on a sound footing with good rates of growth set to be delivered.

If this is the case, why is the bond market priced for something akin to a deflationary depression?

In the US, the 1 year bond is yielding 0.09%; the 2 year is 0.24%; the 5 year 0.86% and the 10 year yield is 1.98%. These yields are without precedent and reflect several factors.  Among those are the massive overhang of spare capacity, horrible state of the labour market, the bankrupt banking sector, housing depression and of course, Fed policy.  The Fed has set its overnight rate at zero for the last three years and have told the market that it will keep this target at least until the middle of 2013.  The Fed has also delivered several tranches of quantitative easing (QE - printing money) which means that bond yields are held down by the simple weight of money which has come from the proverbial printing presses.

So which is right?  The economically optimistic stock market or the gloom and doom bond market?

The bond market is usually right.  This time it is no different.  While there have been some greatly encouraging signs in some of the recent data flow in the US, this good news is likely to be a function of the easy policy settings mentioned above, plus even an unseasonally warm winter.  It's the adrenalin injection creating a sense of optimism, rather than any long run underlying structural improvements.

Perhaps think of it another way.

Where would the economy and stocks be if Fed policy was normal?  How would it react if the Fed reversed its QE policy and hiked the Fed Funds rate to 3% - a level near the long run average?

I suspect it would be very grim.  The US economy at  the moment could not cope with anything other than super easy monetary policy which is why the Fed is still along way from moving the patient from intensive care or in other words, from taking back the QE and hiking interest rates.

I will only be confident of a fully fledged US recovery, one that is sustainable and enduring, when QE is unwound and the Fed Funds rate is on its way to 3%.  I'm not sure when that will be, but we are talking many years.  This is one reason why the US stock market looks to be overly optimistic and over-valued and bonds are probably correct to be priced for a less rosy performance for the economy in 2012.

The above article is not investment advice. 

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