Hidden Dangers or Illusory Traps?

An article on the WSJ site recently makes the case that investors are facing probable losses in both stocks and bonds as the two major asset classes are positioned to deliver returns below inflation in the US. While this is an alarming idea, especially considering how low inflation is, there are several questionable parts in the article.

The real issue this points out is that the stock market is rising as though the economy is doing well, but bond yields are staying low as though the economy is doing poorly. Which one is it? And as things change, will both markets lose money?

Why It’s Dangerous

First, on the risks of stocks it quotes a money manager who says that stock prices are high because people believe the downside risks to be limited (meaning we are overconfident). I’m not sure if that’s the case among large traders but what I’m hearing from individual investors and the media does not reflect that view. This article is just one example of the general fear of stocks that is spreading now. And yet the prices remain high in spite of that fear.

The author also mentions the Shiller P/E ratio, which is now at a level that has historically indicated poor returns. That is something to watch, but over-reliance on a single indicator is often dangerous.

For bonds the main threat is the current low interest rates. Both government and corporate bonds have very low yields. If yields stay stable or drop they won’t provide much return, and if yields rise there is a threat of capital losses.

As the article correctly points out, stocks and bonds can move in the same direction. The boom in the 80s and 90s was good for both markets until it slowed down in the last decade. But in the 1940s and 1970s, a balanced portfolio would have had a negative real return. I believe one big reason for this is that in all 3 time periods there were major events in the economy and the world that were unexpected, causing a revaluation of investments. Unfortunately it is particularly difficult to predict unexpected events in the future.

What Will Happen Next?

We know that the actions of the Fed are influencing the market. If the economy does well, the Fed will withdraw support as the author notes and possibly cause asset prices to fall (we don’t know by how much). If it doesn’t, corporate profits will fall and the Fed will take action again, lowering bond returns.

The conclusions are where things start to get shaky. I agree that it’s hard to see things ending well for bondholders which is why I don’t have any money in bonds. However I don’t know if the low yields are really a signal of economic trouble. After all the Fed is currently openly manipulating the bond market, so we can’t say that it reflects true market views. Maybe the current economic strength would lead to bond yields 2-3% higher without that manipulation, giving us a better view of what’s happening now.

When it comes to the stock market there are as many good signs as danger signals. The current P/E ratio is reasonable, so it’s not pointing to extreme overvaluation. Profits are rising quickly as corporations stockpile cash and cut costs (including refinancing debt to lock in low interest rates for a long time).

The biggest argument you can make against stocks is that profits might fall. If they do, then current stock owners are overpaying. That is a real risk. But something like that is also hard to predict, and once again the market prices remain high in spite of that danger.

If profits don’t fall then it’s hard for things to go wrong in the stock market. Investors may gain confidence and drive the prices up. Or prices may drop because of a withdrawal of Fed support or many other reasons, which would make it even easier to pick up shares in profitable companies. If we get to a P/E ratio of 10 and a dividend yield of 5-6% in the broad market indexes, I’ll be leveraging our investments to take advantage of that special opportunity.

Expect the Unexpected

If I had a large allocation to bonds I would be pretty worried right now. Outside of that there are risks but we seem to be in a balanced investing environment. As always, those who are prepared for the possibility that they may be wrong will do the best.