LOOKING FOR A U-TURN
Stocks are leading bonds by a comfortable margin this year, but Mr. Market may be plotting for a reversal of fortunes.
The motivation for considering such an apostasy in a world that holds equities near and dear comes by way of recent action in the 10-year Treasury Note’s yield, which dipped below 4.80% yesterday for the first time since March 29. Since June 28, the recent top in the price of money on the benchmark Treasury, the 10-year’s yield has dropped more than 40 basis points.
The trend in yield is down, which means demand for bonds is up. Nonetheless, the surge of buying fixed-income securities of late still hasn’t reversed the edge that stocks hold over bonds this year, but the odds for a turnaround are looking better, or so we’re told. For the moment, however, the S&P 500 is still up by 5.3% this year on a total return basis through yesterday, while the Lehman Brothers Aggregate Bond Index has climbed only 1.7%.
The catalyst behind the notion that bonds may wind up the winner in the two-legged asset-class performance race for 2006 is the expectation that the economy’s slowing. Some are even going so far as to predict that a recession is coming. Nouriel Roubini, an economics professor at New York University, on Sunday wrote on his blog that the “U.S. economy will fall into a recession by early 2007.” Such talk is inspiring the bond market because it implies that interest rates will fall, delivering big gains to fixed-income securities along the way. If so, stocks would take a hit, or so the history from past recessions suggests.
Recent data has provided a degree of support for the economy-is-slowing view, and as a result the bond bulls have become emboldened for their cause by backing up their predictions with cash. Indeed, the only trend that impresses Wall Street is one backed by money, and so the rush to Treasuries of late has more than a few financial types sitting up and paying attention.
But despite the gush of bond buying in recent weeks, the road to relative outperformance is still booby trapped with anti-clarity cluster bombs. Chicago Fed President Michael Moskow yesterday tried to throw some cold water on the bubbling expectations in the bond market by warning that the Federal Reserve may still have more rate hikes up its sleeve. Yes, the Fed ended its two-year campaign of tightening at its last meeting on August 8, but Moskow (who’s not a voting member of the FOMC) said yesterday that higher rates may yet be required for slowing inflation’s upward momentum of late.
“My assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low,” Moskow said yesterday via Bloomberg News. “Thus some additional firming of policy may yet be necessary to bring inflation back into the comfort zone within a reasonable period of time.”
Perhaps, but the bond market doesn’t seem inclined to agree, if the ongoing fall in the 10-year’s yield is any indication, and it is. Perhaps that’s because there’s a range of opinion on inflation’s outlook among the Fed heads. If you don’t like what you’re hearing from Moskow, you can shop around for a more comfortable bout of opining.
For those disposed to consider the alternatives, Atlanta Fed President Jack Guynn offered a fresh dose of soothing words yesterday. After a farewell talk warning of the need for vigilance in combating inflation, Guynn then told reporters that “I am comfortable that policy seems to be, at the time of the last meeting, properly calibrated for my best forecast,” Bloomberg reported. Inflation, Guynn predicted, will slow in the “medium term.”
Anything’s possible in the short term, of course, which makes betting the ranch on either stocks or bonds for the foreseeable future so precarious in the here and now. Much depends on whether Moskow or Guynn’s forecast prevails. No matter, traders are making their bets and accepting the associated risks.
For everyone else, there’s still a little invention known as diversification. And by that measure, a simple 50/50 split of stocks and bonds has fared well over time, a trend we expect we deliver no less comfort going forward. Consider that for the past five years, an even mix of the S&P 500 and the Lehman Aggregate Bond indices (both of which are available in mutual fund and ETF proxies these days) generated an annualized total return of 4.45% for the five years through yesterday. That, by the way, is ahead of the S&P 500’s annualized 4.0% performance over that span and below the Lehman Aggregate’s 4.9%. One side or the other is always up, and the other is down. Diversification is many things, but extreme isn’t one of them.
As such, taking a performance slice born of some mix of the two looks eminently reasonable as a long term proposition. Alas, the world is focused on what’s on tap for tomorrow.
And with that, we conclude our lecture and return you to your regularly scheduled horse race….