The Disconnect Between Bonds and Stocks

The current interest rate yield on 10-year U.S. treasury bonds is about 2.6% as compared to about 4% on these same bonds in April of this year.  Those worried about a double-dip back into recession have aggressively purchased the U.S. 10-year resulting in this very low rate.  Comparable rates around the world are similarly low, with German 10-year at about 2.3%.  Japanese 10-year bonds are yielding under 1%, but this is a special situation with years of deflation and the vast majority of such bonds purchased and held by the Japanese themselves.

Now consider stocks.  A buyer of all 30 stocks in the Dow Jones Industrials Average would receive a dividend yield of 2.7%, plus any future dividend increases, plus any future growth in the price of the stocks.  When comparing this to the 10-year U.S. treasury bond yield of 2.6%, a bond buyer is essentially valuing future dividend increases and future stock price growth at zero.  This week we listened to a conference call by a stock mutual fund manager (who manages about $45 billion) where he indicated never in his career had he seen such a compelling case for owning stocks as compared to bonds.

It would seem that only one of these will turn out to be correct- either the case for bonds or for stocks.  Investors should pay close attention to this disconnect as they determine how to allocate their portfolios.

Are double-dip recession risks overblown?

We recently read an economist's pronouncement that the risks of a double-dip recession had now increased from one-in-five to one-in-four.  Another economist we follow stated that while a decline back into recession was certainly possible, it was not at all probable.

Economic problems are getting such a high level of play in the media that one wonders if market participants have overreacted.  The front page of today's Wall Street Journal carries an article discussing how small investors continue to "flee stocks".

The second quarter of 2010 saw the S&P 500 decline by about 11 1/2% amid these concerns.  At the same time many of the market valuation measures continue to improve.  Of course, the U.S. economy could descend into another recession and validate all of those who are reducing their equity holdings, but if equity pricing over the long-term does return to near its historical levels investors may someday look at this as a buying opportunity.

Complacency?

Merriam-Webster defines complacency as "self-satisfaction when accompanied by unawareness of actual dangers or deficiencies."  This may fit the average institutional investor who according to a recent survey by Citigroup have a consensus of S&P 500 return for 2010 of 11% with a greater chance of a sharp upside move than one that is sharply downward.

A few facts:   Dow Jones Industrial Average (DJIA) close on Friday, September 12, 2008 (before the Lehman Brothers bankruptcy announcement over the weekend) was 11,422.  The DJIA then bottomed on March 9, 2009 at 6,547 and has since recovered to yesterday's close of 11,019. 

There were certainly bargains to be had by purchasing (or even holding) at the lows, but what about now?  We see much to challenge returns over the next many years, including huge levels of global debt and a retrenching consumer.  In our view a well diversified portfolio that doesn't merely count on returns from an increasing stock market is more important than ever.  We caution all, starting with ourselves, not to let the significant recovery in stock prices dull our senses as to the risks going forward.