Sunday, August 14, 2016

Can Stocks Move Higher if Bonds Don't?


Unlike "data dependent" economists or media pundits, the jobs of portfolio managers and securities analysts is to attempt to make money for their clients. The past is useful in categorizing what has happened in various periods but our job is to make decisions today about what may happen in the future. The question before me today is: when the bond market is no longer rising can stocks go up in price?

Bonds Drive Stocks Since 2000

John Authers, the very perceptive columnist in the FT Weekend edition compares the performance of bonds to stocks since the prior peak in 2000.  His conclusion is that while stocks performed impressively, bonds did extraordinarily. He further points out that on the basis of inflation-adjusted returns, stocks under-performed bonds by 50%. From a shareholder's vantage point the only positive thing that various measures of quantitative easing (QE) has done is it raised the stock price level as measured by the popular indices. As a matter of fact the surge in the Federal Reserve's balance sheet caused by their bond buying is about equal to the growth in the value of the gains of the stock indices since March 2009. This would suggest that the gains in the stock market were in effect paid for by ballooning the Fed's balance sheet rather than enthusiasm for growing earnings or dividends. No wonder these market gains are called the most unloved bull market.

Bond Market Concerns

There is increasing acknowledgment that the global experiment with QE has not propelled various economies to expand. At the moment the Fed is not increasing its bond buying levels and is telegraphing future interest rate hikes. Already US rates are rising. In the last two weeks Barrons' Best Bond Yield average is up 5 basis points which is the same amount that the average of the nations' banks have raised the rate they pay on Money Market Deposit Accounts, (MMDA). Looking to 2017 one assumes that the Treasury will be issuing bonds to pay for the large or the largest infrastructure program ever by the federal government as discussed by the two main candidates.

Based on history, health, expected restructuring of one or both main parties right now it would be wise as to view the next administration as a one term occupant of the White House which could tie in with a likely recession during the term. Alternatively, according to at least one good technical market analyst a potential peak stock market will occur somewhere over the next six years.

Through the Mutual Funds Lenses

The S&P 500 with dividends reinvested is up +8.40% and the Dow Jones Industrial Average is up +8.64% for the year to date through August 11th . While the average sector fund is up +13.79%, the average US Diversified Equity fund is up only  6.33%. One can see short-term the attraction of bond funds over stock funds when "A" rated bonds are ahead by +8.56%, "BBB" funds +9.60% and High Yield (so-called Junk). +10.71%. However, if one is concerned about intermediate or longer term periods one sees a very different story. In the intermediate five year period on average only the "BBB" funds have a compound growth including their dividends over 5%. They earned 5.34% or essentially their interest payments compounded. On the other hand the average US Diversified Equity fund was up +8.42%. This suggests that over most intermediate and longer time periods stocks have outperformed bonds.

All too often market commentators take the raw net flows into mutual funds as a sign of what investors are thinking and currently supporting; e.g., putting money into fixed income funds and products. These views may prove to be incomplete and naive. At one point in time the bulk of mutual funds sales were made to individuals for long-term investment needs. Somewhere around 2/3rds went into Stock funds and the rest into Balanced and Fixed Income funds. For the most part funds were sold through salespeople or directly through the funds. Within each sale there was a built in redemption usually when the investment need was met or for some unexpected emergency. Today, I believe this type of completion is the main reason for redemptions, not dissatisfaction. What is different today is that selling forces find it more profitable and less burdensome to sell other products to retail individual investors. Thus it appears that money is moving because of dissatisfaction. This will be less of a factor going forward as most of the new money going into mutual funds is for retirement plans and a growing number of tax exempt institutions. This could lengthen the average holding period in funds.

The other misconception about fund flows is the inclusion of the transactions of Exchange Traded Funds [ETFs] and similar products as they presumably have the same kind of holders as mutual funds. For instance in the latest week some $0.6 Billion net came into the combined Equity fund base. What is more significant is that $3.6 Billion came in from two large Index funds. My guess is that most of this money is from hedge funds and other traders who are using Index funds to hedge their individual securities shorts and will sell their ETF positions once they cover their shorts. In the same week on the fixed income side $3.5 Billion went into Fixed Income ETFs, $1.3 Billion in High Yield ETFs and $1.0 Billion flowed into High Grade ETFs. (All of fund flow data is from my old firm, Lipper Inc., now part of ThomsonReuters.)

The First Question: When Interest Rates Go Up Will There be Buyers?

For some time investors in bonds and credits have been able to make money through price appreciation caused by new buyers in addition to the income generated. A period of rising rates will cause fixed income products to get lower prices. I believe there will be a meaningful reduction of flows into these products.

Second Question: Where Will the flows Go?

Long-term investors particularly retirement programs and endowments have a long-term need to generate sufficient income to meet their obligations. If they can not generate the needed funds they will seek investment vehicles elsewhere. Various forms of equity may become more attractive.

Third Question: Why Will Stock Prices Rise Significantly?

Perhaps the best answer is that very few of the market professionals believe that it will. Many of these "experts" have been wrong on Brexit and the rise of various extreme political candidates. Interesting there is relatively low risk because of the previously mentioned unloved bull market. One of the few brave commentators is James Paulson of Wells Capital Management whose latest letter is entitled "Stock investors should look a yonder" where he makes the case for a global economic bounce. He sees a bigger chance for dramatic earnings improvement outside of the US. We have been buying International Equity funds that have portfolios that have lower valued securities growing faster than many domestic funds.

Fourth Question: What is Needed for the Market Bears to be Correct?

As there have always been down markets, we have learned to expect them. Even though we have not had a major decline for sometime, we need to be watchful for such a calamity. For example in a 31 month period from March of 2000 to October of 2002, the NASDAQ Index fell some 78%. While it is interesting that today it is selling above its March 2000 level, it is instructive to note that on a year to date through July 20th, 71% of its gain was achieved by ten stocks. And yes it took 25 years to recover from the 1929 peak. These kinds of declines have been proceeded by extended period of excess enthusiasm which we have not yet seen in at least seven or perhaps even sixteen years. Using price histories that go back hundreds of years some are looking for the next big one to drop over 50%. While this action could happen anytime, at least one technical market analyst believes it is most likely between 2018 and 2022. This somewhat ties in with the next presidential campaign which may be even more concerning than the present dance.
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