Drinking the Bond Market Kool-Aid

Sideways?

While you may have been sleeping or otherwise engaged, the yield on the 30-year Treasury bond crept up from 3.0% to just under 3.5%, before falling back to the current level of 3.3%. Whether this move is the beginning of a trend of higher interest rates remains to be seen, but it gives us the opportunity to examine in more detail some thoughts about bonds versus stocks. The Kool-Aid in question here is the willingness of bond investors to accept near zero or even negative real returns (adjusted for inflation) in exchange for the perceived safety of their principal. Such acquiescence has been driven by fear--a fear that is understandable, and perhaps justified by the harrowing losses suffered by equity investors during the Great Recession and the market volatility that has followed. At some point, though, investors will return to their more normal behavior of seeking decent real returns. When and how that might unfold is a question worthy of our attention.

Low interest rates and surging federal budget deficits are not supposed to go together like peas and carrots, or love and marriage, or Angelina and Brad. At least according to economic theory, government's need to borrow in the credit markets should put upward pressure on interest rates and thereby "crowd out" the private sector borrowers who can actually make the economy grow. The theory, in its simplest formulation, fails to account for the foreign investors who have lots of cash to invest in our bonds because we sent it their way by buying their goods. For some years now we have enjoyed the happy circumstance of having eaten our cake and still having it. The Federal Reserve has been doing its share to help as well, buying bonds to keep interest rates low to stave off another economic downturn. History has taught us that some things that are unsustainable can, in fact, be sustained for long periods of time. But not forever.

With some notable interruptions and reversals, the trend in Treasury yields was up from just after World War II until 1981. Bond prices fall as yields rise, and vice-versa, so this amounted to a 35-year bear market for bonds. When those rates hit 15% in 1981, many investors were so accustomed to the prevailing trend that they didn't see the opportunity staring them in the face. That was, of course, the opportunity to lock in those high yields for a long bull market ride in bonds. Now, with those rates at historic lows, we have to ask whether they are likely now to go lower or start moving up again. This is not a matter of calling the precise turn in interest rates, but rather an exercise in evaluating what bonds, as an asset class, are likely to offer in the way of total real return versus what stocks, as an asset class, may offer. Barring another outright recession, it is difficult to make a case for lower interest rates, and even if yields do not move up dramatically, the status quo of bond returns leaves us with what one investor has called "return-free risk" instead of the risk-free return that the safest bonds are supposed to provide.

Then there is the matter of inflation. The prospect of a sustained rise in prices can be a tempting condition for indebted governments, because inflation transfers wealth from creditors to debtors. If I borrow money from you and then can pay you back with cheaper dollars, then I win--and you lose. Reported inflation can exclude food and energy prices, and this had one observer commenting that this is only good news for people who don't eat or drive or use electricity. It is the housing component that has kept reported inflation numbers low, because housing costs are heavily weighted in the measurement. If we start to get some distressing numbers on inflation, nominal yields will rise, and investors who bought long-term bonds at lower rates will suffer capital losses if they sell before maturity--and those who don't sell will nonetheless see paper losses.

The recent strength in the equity markets, accompanied by notably lower volatility, may be an indication that investors are growing weary of the Kool-Aid. If investors perceive that interest rates are going to remain low, then the subdued volatility and renewed strength in the stock market may cause investors to move from bonds into stocks, or at least to move cash on the sidelines in money market funds into stocks. As I write this (on Monday afternoon), Federal Reserve Chairman Ben Bernanke has been in the news saying that stronger economic growth is needed for more meaningful reductions in unemployment, thus implying that the last thing the Fed wants to see is an increase in interest rates. This reinforces investor perception that interest rates will remain low for, perhaps, the next two years. The Dow is up 160 points, so maybe today investors are forsaking the Kool-Aid and seeking a more rewarding adult beverage.

Here are two lists of stocks that you may want to research further:

Growth


Apple (AAPL, $606)
Celgene (CELG, $78)
Cerner (CERN, $78)
Costco (COST, $91)
Las Vegas Sands (LVS, $58)
Priceline (PCLN, $735)
Qualcomm (QCOM, $68)
Visa (V, $120)
Whole Foods Market (WFM, $84)
Yum! Brands (YUM, $71)



Growth and Dividends:


Abbott Labs (ABT, $60; 3.38% yield)
Automatic Data Processing (ADP, $55; 2.87% yield)
Boeing (BA, $75; 2.38% yield)
Coca Cola (KO, $71; 2.85% yield)
DuPont (DD, $53; 3.12% yield)
Eaton (ETN, $50; 3.08% yield)
Johnson and Johnson (JNJ, $65; 3.53% yield)
Kellogg (K, $53; 3.28% yield)
McDonald's (MCD, $97; 2.93% yield)
Philip Morris (PM, $88; 3.55% yield)

As I have emphasized before, my preference with dividends stocks is to accept lower yields in exchange for a more modest dividend payout ratio (the percentage of earnings paid out as dividends) and a history of dividend increases. We'll take a closer look at some of these stocks in upcoming posts and also consider the possible tax increase on dividends that may be coming with the expiration of the Bush tax cuts in January 2013.

Life is short. Get busy.

Jim



Disclosure/Disclaimer: My family members and/or I own shares of AAPL, CELG, CERN, COST, LVS, PCLN, QCOM, V, WFM, YUM, ABT, BA, DD, ETN, K, KO, and MCD. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.