FMX | Connect – www.fmxconnect.com - (Reported 8/19/2010)
Excerpt from MARKET MUSINGS & DATA DECIPHERING
THE BOND BUBBLE DEBATE REVISITED:“ONE ROSIE” TAKES ON “TWO JEREMIES”
I was desperately trying to resist the temptation to retort to yesterday’s op-ed piece on page B13 of the WSJ (The Great American Bond Bubble by Jeremy Siegel and Jeremy Schwartz). But alas, I have succumbed, and here’s why.
The “Two Jeremies” stated that “from January 2008 through June 2010, outflows from equity funds totalled $233 billion while bond funds have seen a massive $559 billion of inflows.” They describe this as a “rush into bonds.”
The question is: so what? If anything, this shows that the retail client has developed some real financial acumen considering that Treasury bonds have generated a total return of 13% over that timeframe versus -21% for equities. In fact, both the absolute and risk adjusted return on Treasury bonds have been spectacularly superior to equities for the last 10 years. To be sure, past trends cannot be relied on for future performance, but what is not mentioned in the WSJ piece is that households may be deliberately rebalancing their asset allocation because 27% is represented by equities, another 27% in real estate, but a mere 6% is in fixed-income securities.
So maybe Ma and Pa Kettle are moving to correct this mismatch on their balance sheet and adjusting it to capture more income, limit their risks and preserve their capital. We do know with certainty that the median age of the baby boom cohort is approaching 55. As strategists we have to come to the understanding that a powerful demographic trend is gathering momentum, which is generating this insatiable appetite for yield — an era of correcting the underweight in bonds in the aging (but not aged) boomer asset mix while correcting the lingering overweight in equities. This may prove to be a secular shift and it just makes sense to come to grips with what is likely to be a continued divergence in bond and stock performance in the future.
The “Two Jeremies” compare this apparent “bond bubble” to the “technologymania” a decade ago. Some bizarre comparisons, using an estimate of a P/E multiple on the Treasury market of 100x, were cited but were far too opaque for me to fathom. At the same time, it is a legitimate question as to how to quantify whether bonds are overvalued or undervalued at any given point in time. What is more important to identify, at least in my opinion, is what the critical forces are that drive yields up or down. It’s nice to compare what we are seeing in bonds today to what the dotcoms did a decade ago but it’s hardly relevant because the variables that influence speculative stocks are completely different than those that affect the direction of long-term interest rates. Alan Greenspan thought that growth stocks were “irrationally exuberant” six years before the bull market ended.
What finally did end it was not any particular valuation metric but perhaps Cisco missing by a penny on the other side of consensus expectations, leading to a dramatic reassessment of the earnings landscape. If there is one thing we do know, equity prices will track earnings-revision-ratios very closely. Then of course, we had a capital spending-induced recession that practically nobody saw coming in 2001, and we’ve never had a recession without cyclically-sensitive equities enduring a severe bear market.
So let’s fade valuation comparisons between bonds and growth stocks. It’s such a silly argument. Nortel did go bankrupt, as did a slate of tech stocks. Your capital wasn’t preserved — it was extinguished. Nortel was the darling of the day, at one point representing more than 30% of the Canadian stock market capitalization. Equities, by their nature, are riskier than Treasury bonds — some more than others. Obviously, the Bill Millers, Warren Buffetts and Ira Gluskins of this world have in their professional lives managed to find some real gems that generated significant returns for their unit holders. But at no time was your capital guaranteed. So how can anyone compare that to a government obligation with an ironclad guarantee of interest and principal payments? Do we use a tech stock as the risk-free benchmark for funding actuarial liabilities? Or is it the long Treasury Strip? Does a tech stock, or any piece of equity paper, tell you with full certainty what you are going to be paid upon maturity? Or is that the long Treasury Strip? Why even bother comparing these two investment vehicles, they serve completely different purposes and are purchased by two very different mandates.
Furthermore, I feel strongly that this notion that the U.S. government, with all its taxing power and vast holdings of the national assets and treasures (dare we say, including what lies beneath Fort Knox) is going to default someday is completely ludicrous. All we seem to talk about is the gross debt burden. This is not to downplay the fiscal situation, which is dire, but becoming hysterical could lead to poor judgment and decision-making.
To reiterate, it was the macro economic landscape, not the valuation backdrop, that proved to be the undoing for tech stocks in the opening months of 2000. It is far more relevant and useful to discuss what the triggers would possibly be to drive yields higher and on a sustained basis.
Fundamentally, what we have on our hands is a powerful demographic appetite for yield at a time when income is under-represented on boomer balance sheets. At the same time, while fiscal deficits are very high, they are unlikely to expand any further given the recent political backlash against more expansion of the government debt-to-GDP ratio. All the while, the two most significant determinants of the trend in long-term bond yields — Fed policy and inflation — continue to flash “green”, and at a time when the yield curve is still historically steep and destined to flatten. With the process led by ever-lower long-term rates since the central bank has already assured us that short-term rates will remain at rock-bottom levels for as long as the eye can see.
David A. Rosenberg
Chief Economist & Strategist Economic Commentary
drosenberg@gluskinsheff.com
+ 1 416 681 8919
Source: Market Musings & Data Deciphering
http://www.fmxconnect.com/
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