Stocks Will Benefit from Bond Bust
Source Robert Duvall
Date 10/08/24/10:08

Stocks Will Benefit from Bond Bust
By: Sheraz Mian

INVESTORS disappointed with the stock market's sub-par performance have piled into other asset classes. One such red hot asset class is the bond market, which has been attracting a lot of investment dollars, largely at the expense of stocks.

But that sizzling rally may be nearing its end. No prizes for guessing which asset class will benefit from the coming bond bust.

Why do I have such a negative outlook for the mighty bond market? Well, the core rationale behind that rally, particularly in the Treasury bonds, can't stand up to a critical review. My goal here is to convince you that bonds have had a great run, but their best days are behind them. Get ready for the rush of money into the stock market. Stocks are the place to be!

While there are other factors at play as well, the primary driver of this Treasury bond rally is a very pessimistic view of the US economic outlook. Purveyors of this view envision the U.S.'s path to be very similar to Japan's in the 1990s. The Japanese economy was stuck in a spiral of stagnant growth and deflation in that decade. The argument goes that Japan's 'lost decade' was preceded, as is the case with the U.S. now, by the bursting of a real estate and banking bubble.

I don't subscribe to this view. While I acknowledge that the U.S. economy is faced with a number of challenges, I don't believe that we are headed towards a deflationary phase. With the yield on the 10-year bond now at a multi-decade low in the 2.5% neighborhood, it simply can't be compressed anymore. When you see that the dividend yield on the 30-stock Dow Jones index exceeds the 10-Year bond yield, you know that the Treasury bonds are in uncharted territory.

The U.S. is No Japan

While there are numerous similarities between the U.S. today and Japan in 1990, there is one critical point of difference between the two - the U.S. Federal Reserve. The Fed's conduct to date clearly shows its deep understanding of the Japan scenario. With Ben Bernanke at the helm, the U.S. has the most earnest student of Japan-like situations in command. His 'Helicopter Ben' nickname is closely tied to his strong views on the subject.

We have clear evidence that the Fed has internalized two key lessons from Japan's experience in the 1990s. First, be aggressive and non-dogmatic in tackling the issue head-on. And second, heal the banking sector as quickly as possible.

The Bernanke Fed has been extremely aggressive in its response. They not only cut rates to near zero, but committed themselves to keeping them there for an 'extended period'. And they have been about as unconventional and non-dogmatic as any major central bank has ever been. In fact, many commentators have been critical of the Fed for being too aggressive in the use of its balance sheet to ensure monetary easing.

Not only did Japan's central bank do almost the opposite of what the Fed has been doing, but they took too long to address their banking mess. They didn't fix their banks until 2002/2003. Their dilly-dallying through the 90s allowed zombie banks with huge non-performing loans to operate. This placed a heavy burden on the Japanese economy.

In contrast, the U.S. moved with breakneck speed to fix its banks - remember the 'stress tests' and TARP funds. Banks were encouraged to write-down their assets and helped to recapitalize their balance sheets. A very steep yield curve, a direct result of the Fed's aggressive actions, is helping the healing process along.

While issues no doubt still remain with U.S. banks, they are the polar opposites of the Japanese banking sector in the 1990s.

Sustainable Economic Growth

Deflation in the U.S. remains a risk, but the Fed's aggressive actions significantly lower the odds. The discussion above shows that while the two economies faced similar shocks (real estate bubble bursts), the U.S. policy makers are benefiting from the missteps that caused and entrenched the Japanese deflationary spiral. The only scenario where the odds of deflation actually increase is if the U.S. economy goes into a double-dip recession. And I consider that a very unlikely scenario.

The economy's growth momentum has slowed. But this is more in the nature of a temporary pause than a new downturn. Estimates for the third and fourth-quarter GDP growth rates have been coming down in recent days, but remain in the 2% to 2.5% range. This gives the economy enough momentum to push above-trend growth levels again next year.

While household deleveraging remains a weak spot, particularly given the protracted labor market softness, the corporate sector is in excellent shape. This was clearly borne out by the solid second-quarter earnings reports and managements' earnings outlooks for the rest of this year and next. A very profitable corporate sector, flush with cash and beginning to loosen its purse strings for capital investments, remains the economy's core growth asset. With the labor market continuing to improve, albeit at a slower-than-expected pace, the economy's growth momentum will further widen.

With Germany recently reporting its best economic performance in years and the Chinese authorities expected to ensure a soft landing, the international growth outlook remains supportive for the U.S. recovery as well.

What Does It Mean For Your Portfolio?

If the economy is on course to avoid a Japan-like scenario and remain on a growth trajectory, then what do we make of all those investment dollars going into bond funds referred to earlier?

I expect those investors to be in for a shock in the coming months and quarters. While treasury yields may go down some more due to continuing fears about the macro picture, the overall trend is clearly upwards. Treasury yields are bound to rise from the current historically low levels. And as this trend comes into play, bond investors will be facing significant capital losses.

Most individual investors get bond-market exposure through mutual funds. Take a good look at such holdings and cash in the gains while the going is still good. You can replicate any investment strategy and style in the stock market. The coming bond bust will unleash a torrent of new money in the stock market; get ready for that ahead of time.

I have never been a big fan of passively owning broad stock market indexes through mutual funds. I believe in conscious and deliberate stock picks, using a disciplined investment framework. Stocks of companies that offer compelling products and services, enjoy above-average earnings prospects, and trade at reasonable multiples offer the best bet to generating market-topping returns.

Sheraz Mian

Sheraz is the Director of Research at Zacks Investment Research where he relies on access to valuable data to assess winning stocks and funds.

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