My point here is that simplistic blanket statements are no help at all in making investment decisions. How have investors gotten killed in the past? By falling for statements like these:
High-growth stocks are a good thing (1970).
Bonds rated below triple-B aren't appropriate for investment (1977).
No one will ever buy equities again (1979).
There can never be too many disc-drive manufacturers (1988).
The Internet and optical fiber will change the world (1999).
- Home prices can only go up, and there can't be a nationwide surge in mortgage defaults (2006).
- High yield bonds are unattractive given the risk of Armageddon (2008).
Most of today's positive articles about bonds are totally devoid of discussion of prices and probabilities. But it's only by assessing those things that attractiveness can be determined.
What To Do Now?
Ever since the financial crisis started in mid-2007, I've been saying any recovery would be lackluster and investors shouldn't be planning on prosperity. To me that called for investing in solid, stable, non-cyclical companies; avoiding levered companies and strategies; emphasizing risk-controlled strategies and managers; and, perhaps foremost, holding more bonds and fewer stocks. These were general principles: my own blanket statements, if you will. But now that stock prices have drifted lower and bond prices have continued to surge, I find I must reconsider the emphasis on bonds.
How are bonds priced today? What returns can we expect? Let's consider that 2'/2% ten-year note. With regard to Treasury securities, where it still seems safe to say there's no credit risk, there are three possible states of nature.
- If we buy at a yield to maturity of 2'/2% and interest rates don't change, we'll enjoy an annual return of 2'/2% per year for the next ten years. (With interest rates unchanged, there'll be no change in price other than from accretion to par at maturity, and we'll be able to reinvest the interest payments at the yields available at the time of purchase, an assumption implicit in the yield-to-maturity calculation.)
- If interest rates fall in response to economic weakness or deflation, we're likely to see interim appreciation. And if we sell at the appreciated prices, our holding-period return will exceed the yield to maturity at which we bought. Even if we just hold, our 2'/2% notes will be desirable museum pieces, as in, "Do you remember the good old days, when you could get 2'/2% on Treasurys?" (In truth, though, how much lower can yields go from here?).
- Finally, if the economy, inflation and interest rates surprise on the upside relative to today's low expectations, having locked in a yield of 2'/2% won't turn out to have been a good thing. From 2'/2%, it's clear that rates have much further to go up than down. Any substantial increase in bond yields would bring meaningful interim price declines. It must be borne in mind that holders of the bonds of creditworthy issuers don't have to worry about permanent capital losses (unless they're frightened into selling when things are down). A bond that's money-good will outlive any negative interim fluctuations, pay par at maturity and deliver the yield at which it was bought. So the real risk for people who invest in these bonds is that their returns turn out to be sub-par under the circumstances. If inflation turns out to be normal, investors in the 2'/2% note may end up with no more purchasing power down the road than they have today – that is, a real return of zero. Thus, if there are positive surprises in the environment, bond holders are likely to wish they had stocks instead.
Portfolio construction is supposed to strike an appropriate balance between safety and certainty on one hand and aggressiveness and gains-seeking on the other. The key question is whether today's bond buyers are leaning too heavily toward the former and forgetting too much about the latter. Are they too pessimistic and thus honoring uncertainty to excess?
An article by Richard Thaler of the University of Chicago, in The New York Times of August 22, makes an important point. He wrote about CFOs, but I think it's largely the same for investors:
. . . the confidence limits [of their forecasts] widen after bear markets, mostly because estimates at the lower bound become more pessimistic. This puts a new light on the recent comment by Ben S. Bernanke . . . that the economic outlook was "unusually uncertain." . . . Yes, things feel more uncertain after bad times,
but severe market downturns tend to occur after long bull markets when we are feeling least uncertain.
In other words, investors become so accustomed to good times that bad times seem unsettling in comparison. That could explain excessive appetites for the safety of bonds and thus why, according to Deutsche Bank, "the top 10 lowest-yielding U.S. corporate new issues in history have been sold in the last 14 months" (Bloomberg, August 16).
And what about sellers of stocks? I'm no longer an "equity guy" by profession, and Oaktree manages far more bonds than stocks, so this isn't a commercial. But I feel investors may be overlooking some substantial merits on the part of stocks today (data from Bloomberg, August 16, except as noted):
- Having made their organizations lean and benefited from declining floating-rate interest costs, cheaper labor or staff downsizing, companies are doing a good job of making money despite today's lackluster economic environment. "Earnings for S&P 500 companies may rise 36% in 2010 and 16% in 2011, the largest two-year advance since 1994-5."
- Rather than spend that money on expansion or acquisitions, most companies are piling it up. "The Federal Reserve reported in June that nonfinancial companies were holding cash totaling more than $1.8 trillion, having built up their hoards at a rate unmatched in more than 50 years" (LA Times, August 25). This pile of cash adds greatly to companies' financial security and to the potential for dividend increases or stock buybacks in the future.
- Finally, those selling or shunning stocks today seem to be overlooking some very attractive valuation parameters.o Price/earnings ratios are lower than usual. "The S&P 500 trades at 14.4 times annual earnings, compared with an average of 16.5, according to data . . . that goes back to 1954." Not giveaway levels, but 13% below the post-war average.o Annual free cash flow for American companies excluding banks is running at 6.8% of their market value. This "cash flow yield" is roughly capable of being compared against the yield on bonds. Although (unlike dividends or interest) the cash flow isn't necessarily received by investors as it's earned, it should contribute to stocks' value one way or another.
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