May 3, 2006
DOES THE BOND SLUMP HAVE LEGS THIS TIME?
Pimco's Bill Gross pulls no punches in assessing America's investment alternatives in his freshly minted commentary for May. He's been wrong before, of course. It wasn't that long ago that he predicted that the Fed wouldn't keep raising interest rates. No matter, as the predictions keep coming:
"Higher inflation, higher personal and corporate taxes, and a lower dollar point U.S. and global investors away from U.S. assets and toward more competitive economies less burdened by health and pension liabilities – those personified by higher savings rates and investment as a percentage of GDP," writes Gross, manager of the world's biggest bond fund. If such a hint at his thinking doesn't suffice, he clarifies with, "Need I say more than to sell U.S. assets and buy Asian ones denominated in their local currencies; or if necessary to hire a global asset manager with sufficient flexibility and proper foresight to thrive in an increasing difficult investment environment?"
Bashing the U.S. investment outlook hasn't exactly been out of favor in recent years, although it's been a losing proposition when it comes down to dollars and cents. Despite the macroeconomic smoking guns that have been casting dark clouds over America's prospects, investors the world over have seen fit to ignore the strategic and favor the tactical. And it's paid off handsomely, particularly in the stock market.
A determined investor who bucked the then-bearish crowd and bought the S&P 500 Spider ETF in early 2003 is now looking like a genius, courtesy of the fund's 14.11% annualized return for the 36 months through yesterday, according to Morningstar data. That's well above the S&P 500's long-term performance, and probably a good deal more than reasonable minds expect going forward.
In any case, the rear view mirror doesn't reflect quite as favorably on bonds. The Vanguard Total Bond Market Index fund, which tracks the Lehman Aggregate Bond Index, has more or less treaded water over the past 36 months, posting a spare 2.43% annualized return through yesterday--about half the current yield on the 10-year Treasury.
In fact, the paltry gain for bonds has evaporated altogether in 2006. Vanguard Total Bond Market has shed more than one percent so far this year. But if the fixed-income world is flashing warning signals, you might have missed the caveat if your view came solely via the S&P 500 ETF. Year-to-date, the Spider has tacked on nearly 6%. At that pace, it's still on track for maintaining its impressive run by the standards of the past three years.
To be sure, owning both stocks and bonds satisfies the diversification itch, and this year's divergence in the two asset classes underscores the point. The question is whether the ongoing capacity of stocks to climb is a recognition of what awaits in the future or ignorance of the risks that are increasingly weigh on bonds?
Minimizing what ails the American economy has been popular sport, but the game can't last forever. Just ask forex traders, who've been selling the dollar in droves of late. The U.S. Dollar Index has dropped to its lowest level in about a year, a move confirmed by gold, which continues to soar to its highest level in decades by reaching nearly $669 an ounce as of last night.
Something is amiss in the outlook for America, and strategic-minded souls may be inclined to act on the fears. Maybe. Although the warnings will ring familiar--debt and deficits are the infamous buzzwords on every pessimist's lips--there's been a respite from any fallout. Perhaps it was the global savings glut that primed optimism's pump. Then again, the surge in corporate earnings and the undying desire among consumers to spend kept Wall Street buoyant. As such, who's to argue that the day of reckoning won't be delayed longer still, even beyond a date that sober-minded analysts of a certain predilection think is the absolute outside bet.
Regardless, the warnings are coming out of the woodwork (again), and there's reason to think that Mr. Market is slightly more amenable to gloomy notions in the wake of a bull market in stocks and the compression of risk-premium spreads. Indeed, a mere 250 basis points separates the yield in junk bonds (based on KDP High Yield Daily Index from the counterpart in the 10-year Treasury).
Perhaps the new parlor game will be one of looking for clues that might convince a majority that the glass is half empty rather than half full. A new paper from the Levy Economics Institute--Twin Deficits and Sustainability--has some thoughts on potential catalysts:
While household debt ratios, as well as debt-service ratios, have trended upward, an end to the current sluggish expansion is not likely to be initiated by a sudden wave of defaults and bankruptcies. Instead, it will come when household borrowers and banking sector lenders decide it is time to retrench—to slow the growth of borrowing by, and lending to, the personal sector. Conceivably, this slowdown could trigger a snowball of defaults.
The antidote to pessimism for the stock market is the usual balm: more earnings growth. And on that score, there's still reason to hope. As Dirk Van Dijk of Zacks asserts today, the median year-over-year growth rate for the roughly three-quarter of S&P 500 firms that have reported first-quarter earnings so far is 13.0%. In turn, the trend makes "it very likely that this will be yet another quarter of double-digit growth." He writes that the reports so far have been "amazingly positive, far more so than in the fourth-quarter."
But if it's still easy to be bullish on stocks, what's the argument for buying bonds? Maybe the cautious behavior that's swept over the fixed-income set is more than a fad du jour. If so, should an enlightened equity investor take note or just keep partying like it's the first quarter of 2006? Or, should we simply ask, how confident are you that the historically low correlation between stocks and bonds will hold up in the months and years ahead?
© 2006 by James Picerno. All rights reserved.
Posted by jp at May 3, 2006 10:38 AM
Perhaps your standards are higher. But making 14% a year in a passive stock index fund for the past three years--a rate materially higher than the long-term performance of equities--looks pretty smart by my definition. I think I can find one or two other investors on the planet who'd agree. The problem is that genius is often confused with a bull market, ergo, now what?
Posted by: James Picerno at May 4, 2006 10:30 AM
"Looking like a genius.."
Not be my definition.
Dollar Index down 15% early `03.
Gold has doubled.
Posted by: Jeremy at May 3, 2006 10:29 PM
Of course Gold/Silver have outgained Stocks by a mile. Real returns denominted in Gold prices have been terrible for stocks.
Posted by: Mans at May 3, 2006 12:24 PM
It should be said that his comparison of the future problems for GM and the US as a whole were pretty scary and impressive.
I think he is onto something on two fronts:
1) that we are quietly abandoning the strong dollar policy to devalue the $ and make our debt less painful to repay.
2) that there is to come a day of reckoning where we in the US must acknowledge that our standard of living is to decline in absolute and relative terms due to wage compression brought on by global labor arbitrage and other globalization pressures.
Additionally, I really wonder what our macro situation would look like here in the US if the asset pump the Fed turned on hadn't produced such a huge housing bubble and the resulting construction boom that has delivered much of our GDP growth.
As a consumer of Gross analysis, I was pretty shocked to see him express such pessimism.
Posted by: Hit The Bid at May 3, 2006 11:58 AM