This article is a guest contribution by Dr. Charles Lieberman, Chief Investment Officer, Advisors Capital Management.
Date: 8/16/2010
Individual investors are gone from the equity market more so than any time in decades, pushed out by poor returns, unfathomable volatility, and concern and disillusion with the political and economic environment. Instead, investors have turned to bonds, as they seek safety and the return of their capital ahead of investment returns. This search for safety will prove counterproductive and investors will get hurt down the road once the economy recovers. Their flight from stocks has made the equity market the place to be for the foreseeable future, although only those with some staying power will reap these benefits.
The flight to safety is demonstrated most clearly by the flow of investor funds into bond funds and bonds. IBM recently issued a $1.5 billion 3-year note to yield 1.0%, one-half the yield on its common stock. This contrast indicates in the starkest terms that many investors prefer that they get their capital back in three years, even if they earn almost nothing on that investment, rather than risk capital loss by buying the common stock. U.S. Treasury TIPs, which protect investors from inflation, yield zero in the 5-year maturity range. So, some investors are forgoing all return, if they can keep their capital inoculated against inflation over this term. Just as impressive is last week's Johnson & Johnson issue of 10-year notes at 3.15% in contrast with the 3.7% yield on its common. It is very likely that the stock investor will earn a return that is a multiple of the return earned on these bonds over a ten year horizon.
This preference for bonds over stocks is not restricted to just high quality borrowers. High yield bond issuance so far this year has already exceeded $155 billion, versus a record $163.6 raised in calendar year 2009. So, last year's record level of issuance will be exceeded by a considerable margin. August issuance is normally quite light, but $21.1 billion has already been brought to market. In fact, when we speak to bond dealers in our effort to buy bonds for our clients, finding attractive paper is hard and we have been forced to become very selective in our picks. In contrast, we can easily sell anything we own. We have also heard that bond funds have had to sacrifice their ability to be selective, because so much cash is pouring in, they must buy almost anything available to avoid sitting on mounds of uninvested cash. How did we arrive at this point?
Investors are clearly seeking safety. Their concerns may be motivated by fear that economic growth might lapse, that the Washington political process is so polarized that good policy is hard to win approval, while foreign policy is also fraught with unusual dangers. In truth, I can think of any period in my entire investment career when the outlook has ever been clear and there werent major concerns. Uncertainty has always been high.
The economic outlook is "unusually uncertain", as suggested by Fed Chairman Bernanke, a rhetorical flourish that supports current apprehension. Looking back, I recall forecasts of a double dip recession in every single recovery I have lived through, even though not one ever flamed out. People are always nervous that bad times will come back. That history notwithstanding, a double dip recession forecast has become fashionable, once again. However, the data suggest that growth has slowed in 2010, not that a second recession has started or is even likely. Companies have refinanced themselves with enormous volumes of debt and equity issuance. Public companies are sitting on about $1.7 trillion in cash, S&P 500 companies are sitting on about $1trillion, profit margins have widened very sharply and profits and cash flow are quite robust. Analysts have been caught up in this atmosphere of caution and companies keep exceeding and raising their profit forecasts above that of analysts. The typical company has too much cash and needs to figure out how to use this asset more productively than earning a few basis points. Companies have been investing in new equipment and technology in their effort to improve competitiveness, but despite this sizeable rise in capital investment, retained profits exceed investment, so the cash hoard keeps getting larger. So, acquisition activity has picked up and most firms have used cash to finance these deals. It is hard to see the basis for a significant retrenchment in the corporate sector under these conditions.
The health of the banking system is also greatly improved. Late in 2008 and early in 2009, there were reasons to fear that the entire financial system might unravel, severely damaging the overall economy. After the failure or near failure of Lehman, Bear Stearns, AIG, Fannie Mae and Freddie Mac, a financial collapse was not a farfetched possibility. Instead, the banking system was recapitalized, bad loans were written off, and government loans have been largely repaid. Yes, borrowers are not borrowing, but this has as much to do with the flush condition of the corporate sector as it does with the caution of bankers to lend. Good projects can get financing, as is easily demonstrated by the extraordinary low rates available in the bond market.
