Which Way for Stocks? Bonds Give a Clue
Sherlock Holmes sometimes solved great problems just by lolling around in his smoking jacket and puffing at his pipe for hours. In “The Man With the Twisted Lip,” Holmes solves the case with ease without leaving his flat.
An incredulous Mr. Bradstreet asks, “I wish I knew how you reach your results.”
Holmes replies: “I reached this one by sitting upon five pillows and consuming an ounce of shag.”
In that spirit – sans pillows and tobacco – it seems I’ve spent a lot of time this week sitting around reading odd stuff and mulling over clues. I did find some clues in the bond market that tell us where the stock market may go next.
You’ll be surprised at what these clues say.
They come from a look back at history. One analyst found that when the beauty contest between stocks and bonds sets up as it does today, bonds get destroyed. “For the third time since the 1850s,” he writes, “30-year rolling real bond returns are near equity returns, and on both previous occasions, multi-decade bond bear markets followed.”
And for stocks? Well, this same fellow deduces from the same history that stocks could rise 30% or more as inflationary expectations rise.
Before you scoff at this outbreak of optimism, consider that this is from one of the great students of bear markets. He knows their ways and histories. Heck, he wrote a book about them, The Anatomy of the Bear. And he thinks we’re in a secular bear market for stocks now. (“Secular” being a cherished Wall Street fancy dan word. It means “long-term.”)
So who is this guy and what gives?
Let me preface this discussion by saying that I don’t usually like to guess about where the stock market may go next. We simply play the ball where it lies, like an honest golfer. Besides, in my investment letter, Capital & Crisis, we don’t buy the stock market. We buy specific stocks. I think it is infinitely more useful to spend my time looking at specific stocks and to just be picky about what we buy.
Still, I sometimes like to think about the great ebb and flow of market movements. Today is one of those days.
Anyway, the analyst quoted up top is Russell Napier, the global macro strategist for CLSA, an investment firm. He lays out his case in a report titled “It’s Not the Economy, Stupid.” Napier shows that relative to bonds, US stocks are cheaper now than at any time in the past 50 years. He speculates that this is probably due to widespread fears of a “double-dip” recession. “But unless that double dip produces a 60%-plus decline in earnings,” Napier writes, “equities are cheap.”
Of course, we can’t rule anything out, and Napier doesn’t. But Napier writes that “at these relative valuations, investors have consistently made material positive returns in every period since the late 1950s. Yield compression alone could push US equities up more than 30%, and if inflation concerns increase, gains could well exceed this.”
Now, before you declare the man insane, I think there is some merit to what he is saying. And it comes with a powerful qualifying comment, which I’ll get to below.
But here is the key…
Napier compares bond yields with stock dividend yields. Dividend yields on stocks are very close to those of 10-year Treasuries. This situation last existed from December 2008 to May 2009. Investors who bought stocks then did well. You otherwise have to go back to June 1962 to find such a narrow gap. Again, investors who bought then cashed in as stocks rose 26% over the next 12 months. There are other historical examples.
As Napier writes, “Investors have consistently made good profits at the current yield gaps and ratios since 1958.”
In any event, this is where we are.
Napier’s qualifier is that he’s making a relatively short-term call. Longer term, he says stock valuations ought to decline as bond yields rise. In the early going, though, stocks often rise. As he writes, “This is likely to be the beginning of a very long bear market in bonds, but there is much in the historical record to show that equity prices can continue to rise in the early stages of a bond bear market.”
I won’t tackle that historical record. I will add that valuations can come down without stock prices dropping. Earnings can rise and stock prices can rise more slowly. This is what we’ve seen this year, as the market overall showed much-improved earnings, but the stock market is pretty much where it began the year.
Long term, Napier is not fond of stocks. He simply recognizes the ability to make large gains even in the context of a downward-sloping market. As he points out, the 1970s were an awful time to buy and hold stocks. Yet the 1970s also produced some of the best one-year holding periods for stocks. “Another such great opportunity now presents itself for the nimble and the bold,” Napier writes.
In short, bonds look sunk; but as for stocks, there is room to run. We’ll see if this clue-deducing is as good as Sherlock Holmes’.