By Joseph Y. Calhoun
The reports of my death are greatly exaggerated.
Over the last few years I’ve read a plethora of articles about this supposedly hated bull market in stocks. It is said that this is the most hated bull market in history and while I’d argue with that a bit, it isn’t far off the mark. The desire to be the one who calls the top on this historic bull is powerful and many have succumbed to that siren call, yours truly included. The psychology of that need is interesting indeed and comes, I think, mostly from a sense that the game this time around has been well and truly rigged. Capitalism as it has been practiced these last few decades is not the capitalism of Adam Smith and it surely hasn’t lived up to the values, the moral sentiments required of a fair and just society. This bull market has been built not on fundamental improvement but rather a shaky foundation of financial repression, greed and irrational expectations. But it marches on and the bull bandwagon gets more crowded by the day. It may be hated but somebody’s buying.
But when it comes to bull markets that are hated the dislike of this little 6 year jaunt for stocks pales in comparison to the opprobrium heaped on the bond bull market that started so long ago, back when I actually still had hair. To be exact the bond bull market started on September 30, 1981 and yields have been falling ever since. Sure, there have been down years during that run but anyone who bought long term bonds back then, when computers were something that occupied entire rooms (I remember writing and running Fortran WATFOR programs using a card reader around that time), has enjoyed one of the most historic bull runs ever. And it has been doubted the whole way up, the end always nigh, inflation about to escape its Fed shackles.
Just last week an all star lineup of legendary investors opined on the death of the long bond bull market. Warren Buffet, Leon Cooperman and Bill Gross all said last week, in one way or the other, that the bond bull market is dead. We also had Greg Ip of the WSJ explain to us why it is bonds that are overvalued and not stocks, proof if any were needed that when it comes to portfolio management Mr. Ip is a fine writer. Mr. Gross, in a maudlin investment outlook piece for Janus, finally acknowledged what most in the business have known for a long time – that he’s the bond king more due to longevity – his and the bull market in bonds – than any great investment acumen. In any case, he’s decided that since he’s getting older and he’s going to die someday, the bull market must be ending. Or something like that; Gross’s commentaries are increasingly incoherent, at least to me.
Gross also opined recently that the German Bund was the short of a lifetime and with yields in negative territory that is hard to argue with. Bunds did indeed sell off after Gross’s comments and that apparently caused all kinds of volatility in other markets. Or at least that’s what I read in various financial publications so it must be true. What came to my mind, though, upon hearing that short of a lifetime call was that I’ve been hearing the same thing about JGBs for most of my career. I think I first heard it sometime in the mid-90s and those trying to call the top in Japanese Government bonds have yet to make a nickel – or at least one that lasted long enough for them to spend it – for going on 20 years. Bunds may be the short of a lifetime but if JGBs are your template that might depend on how much lifetime you have left.
Of perhaps more importance than the yammerings of an aging bond manager is the opinion of Janet Yellen who decided last week was a fine time to let everyone know that stock valuations
generally are quite high. Not so high when you compare returns on equity to returns on safe assets like bonds, which are also very low, but there are potential dangers there.
Well, no stocks are not “so high” when compared with returns on safe assets and like most people Ms. Yellen’s concern seems to be that interest rates will have to rise in the future and that could make stocks look a lot less appealing. And that’s a problem for a Fed that has placed so much emphasis in recent years on the wealth effect on the economy. If rising stock prices are a positive for growth – and that belief sure seems to have played a large role in this bull market – then falling stock prices are the reverse and a cause for concern at the Fed.
But what if Yellen – and most everyone else – is worrying about the wrong thing? Everyone seems to be assuming that interest rates have to go up and the higher discount rate is what will pull stocks down. But there is a rather large assumption in that scenario, mainly that the growth of earnings continues at least at the current pace or better. The future return on stocks is dependent not just on the discount rate applied but also to the future stream of earnings that are being discounted. It is beyond interesting that everyone is focused on and fears a change in the discount rate but show little concern about the possibility that they’ve overestimated the earnings stream.
Why do rates have to rise? Well, I don’t think they do. At least not on the long end of the curve that matters for stocks. The Fed may indeed hike rates this year on the short end – that’s the consensus anyway; I don’t think they’ll get there this year – but the long end is a different story. The 10 year Treasury yield generally tracks nominal GDP growth so if long term rates are to move higher that will involve either a change in inflation or real growth expectations. Just recently, as the dollar has backed off and oil prices have moved higher, long term rates have risen; rising inflation expectations moved long term rates higher. We haven’t seen much change in real growth expectations. But if the recent rise in yields is based on rising commodity prices it probably won’t last. If lower gas prices weren’t enough to spur spending what do you think will happen if they keep going back up?
The most important economic release last week was not the employment report but the productivity report. What it showed is that productivity continues to stagnate, falling for the second straight quarter, continuing a trend of weaker growth that started at the turn of this century. With weak population growth, still weak workforce participation and low productivity growth, higher economic growth – nominal or real – is going to be darn hard to come by. And as long as that remains true – and I see no reason for it to change anytime soon – the odds of a big sell off in bonds, a bear market, are and will remain, quite low. And if – when – we have another recession those long term Treasuries will be a very important part of your portfolio, zigging when your stocks zag. That is, after all, why you own them in the first place – as a hedge against recession. Long bonds aren’t dead yet.