Why is everyone so convinced the low bond yields will push investors into stocks? Earlier today, I read about an interview with Mobius, the famous emerging markets portfolio manager at Templeton, where he highlighted:
“People are now beginning to realize that they cannot be sitting on bonds that are paying one, two or even three percent, when inflation is running higher than that,” Mobius said, adding that investors would look increasingly at equities as an alternative.
“If you look at equities of course, the yields are much, much greater than the bonds.”
The sentiment has lately been a favorite of pundits on CNBC and everywhere else. The argument is that given low bond yields, the yield on equities is looking attractive. Additionally, given that inflation is going to rise, stocks are a better investment than fixed income. Two separate reasons, both of which are flawed.
Let’s take the argument that equity yields are higher than bond yields. So investors are currently demanding a higher yield from the more volatile asset than the less volatile asset? Did you know that this used to be the default scenario? Equity investing used to be viewed as risky, and bonds were the refuge of the conservative investor. Most investors until 1950 were quite comfortable with a higher yield in stocks, specifically because they were riskier. This relationship flipped with changes in the tax code, the advent of EMH, the invention of the 401K, discount brokerage, etc. Most investors, though, grew up with bond yields higher than equity yields and can’t imagine the opposite. Now, I’m not saying don’t buy stocks . . . I’m just saying that if you’re going to buy stocks, the yield pickup will come with a volatility pickup that you need to accept, and in that light the yield, by itself is not a reason to invest today.
The second argument, that stocks are a good inflation hedge, rests on two assumptions. The first is that we’ll experience (or are already experiencing) inflation. Choose your metric and statistic, but in the end, every individual will make up their own mind on whom to believe. The second assumption seems more flawed – that stocks will provide a hedge. Here’s where magnitude will matter. Stocks may provide a hedge against low to moderate inflation, since they can theoretically increase sales to keep up with inflation, however, in periods of high inflation that has not been the case. More importantly, we are coming off historically high margins. If an investor does indeed expect inflation to hit, then traditionally, margin compression should occur anyway, but certainly from this high starting off point. An investor would need to believe that stocks would rise despite the margin compression, and would benefit from a significant P/E expansion – a highly unlikely scenario in a time of price instability (high inflation or deflation). (For further reference, check out our previous discussions on the Y-curve.)
Where does this leave us? It leaves us at a much more negative point than most analysts would conclude. Their conclusion is that investors should seek safety in stocks, as an alternative to bonds. My conclusion is that both are risky at these levels and investors should tread carefully. The biggest bond bull market in history coincided with the biggest equity rally in history (ca 1982-2000), and while bonds continued their run, both assets moved in tandem for a long time. The odds in my book is that they’ll move together again sooner than we want, and it will be in the opposite direction. The reasons to buy equities should come from low valuations relative to assets and earning power – not where we are now. Low bond yields, by themselves, are perhaps reasons to avoid treasuries, but not necessarily good enough reasons to buy stocks.
Relevant ETFs: SPY, IWM, TLT, TBT, SH