Can Stocks Move Higher if Bonds Don't?

Introduction

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 20^th, 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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Implications of “That Was The Week That Was”

Introduction

I am not by nature an Anglophile, but there is much that investors can learn from British History and culture beyond BREXIT. Many years ago there was a television series entitled, “That Was The Week That Was,” or  “TWTWTW” which was a satirical take off on the rather pompous reading of news on British television. As with many theatrical productions from the UK, the concept was brought across the pond and for quite awhile we enjoyed an American version.  Investors last week viewed their own global version of TWTWTW.

One of the standard lessons in geopolitical writings is that war is in effect carrying out policies by other means. Commercial and cultural changes are carried out through international conflicts. I believe that in the future historians will view BREXIT as the beginning of the next phase of global commercial and cultural changes which will dictate different investment policies.

But first we need to live in the present and so on to what may have been a turning point for investors in the TWTWTW.

TWTWTW

I believe that the US stock market action on July 8th, my birthday, was a gift to most equity investors globally. The putative proof of this is the performance of stocks in the last week when the Dow Jones Industrial Average continued to rise to new highs each day and the broader Standard & Poor's 500 rose for four days and just missed a new high on Friday. Some will say the price movement was just a return to a "risk on" attitude. I see it differently for the following reasons:

1.  Instead of the prior stock price leaders continuing to be the performance leaders, it was the laggards that recovered.

2.  Based on stock and bond prices, many of the Index funds also underperformed on a relative basis. (This is not surprising in that most of these indices are anything but truly diversified in terms of quality of issuers.)

3.  In a similar fashion many of the alternative portfolios also under-performed

4.  Many of the non-fully participating institutional and individual investors are complaining that valuations are not at the expected levels for good entry points. They are historically correct, but they are in two traps; first too many financial statements are overstating earnings on a continuing basis. The second trap is that they are only looking at near-term results and at best, next year's expectations not a prolonged view of the future in terms of the issuers and their own needs. (The latter is addressed in the context of the TIMESPAN L Portfolios^®.

The Changing Marketplace

Not all is completely rosy. Both the equity and to some extent the high quality fixed income markets are being driven by Exchange Traded Funds (ETFs), and similar vehicles are growing less fast than in the recent past. If the week is an example, ETF investors are riding a bus that is being passed by faster individual cars.

In addition, the structure of the marketplace is changing with capital being constrained by market makers and they are being replaced by hedge funds which from time to time play a similar role of absorbing temporary excessive flows. One can not count on the same level of support in periods of rapidly building tension than in the past. Too many people view volatility as risk and one should expect bouts of volatility which could be as much as six times what we are currently experiencing.

US Treasuries “Risk-Free?”

Global stock and bond markets are tied together and a problem in one can be disruptive to other markets. Government securities, particularly US Treasuries have been viewed as “risk free,” but because of their use as collateral for “carry trades” they can be forced to react to sudden changes in more speculative securities. Hedge fund professionals view that the Treasury market is increasingly crowded with other hedge funds not simple buy and hold players. In other securities we have seen auctions that failed to be completed. Due to changes in the structure of market capital providers it is possible that we could see a US Treasury auction fail. While on a long-term basis this would not be terrible, in a short-term it could shake the confidence of investors in most markets.

While I believe a portion of our money should be focused on the long-term and use future-oriented valuation approaches, I am very  aware that at some point in the future our old valuation techniques will likely determine the winners and losers.   

The Future through BREXIT and Henry V

The BREXIT referendum "leave" vote was carried by the North of England voters. Some of these had ancestors who were the long bow men that won the battle of Agincourt for Henry V. In this battle some 3500 Englishmen defeated 60,000 heavily armored cavalry led by the cream of the French society who were experts with swords and lances. The English archers impacted the French forces before they could close with the English, and thus won the battle and the war by changing to unexpected and better weapons. I believe this is a model for Mrs. May's government.

The combined arsenal includes currencies, tax rates and rules, lower cost of government and a more efficient bureaucracy, The current French President has already commented that the decline in the exchange value of the GBP was “not helpful.” Interestingly that the fall in the value was not led by the government but by a functioning marketplace that many European governments don't trust. Currently the cost of British exports is high because of EU taxes and regulations. In the months ahead, when freed from these burdens, export prices will drop and market share will grow as trade expands with the Western Hemisphere, Asia, and Africa/Mid East. (This could be a bit deflationary, but positive for consumers. Further, this is part of the trend started by the current leadership in China to favor consumers over production workers.)

I suspect that if the UK government can lower its tax burden, more companies will chose to headquarters there. We are likely to see more tax-motivated inversions from both European and US companies. One of the ways governments can lower their costs and improve the efficiency of delivery is to outsource to the private sector much of what they do now. Undoubtedly there will be a fair number of mistakes made and then corrected. Nevertheless, costs will come down and consumers will benefit.

Insufficient Retirement Capital & Other Challenges

Further I am guessing that the demographic problems the developed world is facing where the dependency ratios are rising, and where the number of laborers is becoming insufficient to create retirement capital for the retired will be solved by rapid changes in the guilds that control primary and secondary education. The fundamental issues are that in the modern world, businesses can not hire qualified workers and far too many of them do not understand how to work in a competitive society. The question is not the number of immigrants, but the ability to absorb them into a productive and growing workforce. This may well prove to be the biggest task for the new government, but if any nation can solve it, the Brits have now the best chance, because they must.

The New PM

It is quite possible that the second female UK Prime Minister will, in her own way, be as impactful as the first. I believe she has a good chance to lead the developed countries out of the wish for only 2% growth to multiples of that.

While history does not completely repeat itself, the current situation reminds me a lot of the time when Mrs. Thatcher became the Prime Minister. One of my early and important mentors on the New York commuter train, the late Arnold Ganz, became a real believer in her. Because of Arnie in the 1980s I started to invest in UK financial services companies and their investment trusts (Closed Ended funds). For the most part, some thirty years later they have proven to be a good investment. So today, I am betting that the long bowmen of the "leave" referendum will once again hit their targets against a larger group of “experts.”

Question of the week: Do you now have a view where the US Senate will lead the US?

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Did you miss my blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.