Bond Lover, Stock Hater (NYSEARCA:SPY) (2024)

I am bullish on bonds. I remain constructive on a bond market that is in a bull market running 36 years and counting. I also remain bullish on bonds relative to the stocks, for I continue to favor the asset class that has prospects for sustained future tailwinds. And, my bond instrument of choice above all others remains long-term U.S. Treasuries.

Nothing Lasts Forever

I am not a perpetual bond bull, mind you. I recognize that interest rates will not stay chronically low forever and someday will eventually start to rise. And, given how much policy makers have distorted global financial markets, this will all end badly at some point. But in a meantime, that is likely to last at least for the next several years, I continue to favor bonds over stocks. And, when the day of reckoning finally arrives for capital markets, the impact is likely to be felt first and far more profoundly in the stock market than the bond market.

Why Bonds?

So, why do I favor bonds over stocks? Because of the following simplified point.

When the economy is performing well in a sustained growth phase with rising inflation, stocks will do well both on an absolute basis and relative to bonds.

When the economy is not performing well with sluggish to receding growth and disinflationary to deflationary forces, bonds will do well both on an absolute basis and relative to stocks.

What environment have we had throughout the post crisis period? Sluggish economic growth with disinflationary to deflationary pricing pressures.

But what about stocks? Aren't they telling an entirely different story? Indeed, stocks have done famously well during the post crisis period. But why? Has it been due to corporate earnings that are no higher today than they were in 2007 or 2011? Has it been because of the rousing economic recovery? Or has it been because monetary policy makers have pursued a strategy of asset price inflation in order to create wealth that has yet to really feed its way through the economy and is now showing early signs of careening out of control in its own right? The answer is behind door number three. And, for those readers that are ready to extend mocking pity for my favoring bonds over stocks since the outbreak of the financial crisis, don't worry, as I have owned both stocks and bonds throughout. And, after so many years, bonds are still outperforming stocks by my most relevant measure between the two. I'm a lover of total returns but also of risk control and diversification.

What is the economic outlook for the coming years despite the endless optimism for so many years in 2010, 2011, 2012, 2013, 2014, 2015, 2016, and now 2017 that the sustained economic growth breakout with higher inflation is right around the corner either "in the second half of this year" or "early next year" depending on which month is showing on the calendar at any given point in time? Once again for the umpteenth time, the outlook is and will continue to be for sluggish economic growth with disinflationary to deflationary pricing pressures.

But what about corporate tax reform? What about pro-growth policies? All that I will say to this point is beware the latest oasis in the ongoing desert of elusive or misguided fiscal and monetary policies that amount to little to nothing to bring the global economy out of the malaise in which it has been stuck for the past decade now. Putting this most directly, fiscal and monetary policy makers have thrown just about everything including the kitchen sink, refrigerator, and dishwasher at the problem. And, while they were successful at pulling the financial system back from the brink, they simply have not been able to get the global economy back up on its feet in a sustainable way. Sovereign debt levels are through the roof, central bank balance sheets have collectively quadrupled in size, yet none of it has worked. So, why will a few tax breaks that get funneled straight to dividend payments and share buybacks along relaxed regulations that result in marginally increased profitability, but still tight lending standards and lack of high quality employment for those that are still left looking for a job make any ice breaking difference from here.

What will finally break the cycle in the end? The same thing that broke every previous cycle prior to 1987 before policy makers got so heavily involved in the game of trying to micromanage the economy and its financial markets. The answer? Allowing the economy to cleanse itself. And boy does it need a really good cleanse today?

How do you cleanse an economy? Allow it to go into recession. Granted, recessions are hard as people lose their jobs and production is curtailed. I've seen firsthand the difficult and negative direct effects of recessions myself and in my own family. But whether we like them or not, recessions are necessary because they wash out the excesses and curtail the misallocation of capital by redirecting it over time to more productive and healthier purposes.

I'm not suggesting a full blown, destructive depression. But a standard recession that can be massaged and guided through the prudent use of fiscal and monetary policy tools to allow this cleansing process to take place in an orderly way. Unfortunately, policy makers simply refuse to allow this to happen. And, just as we have already seen with the bursting of the technology bubble and the onset of the financial crisis, the longer policy makers delay in allowing the forces of economic nature to run their course, the more destructive the eventual cleansing process will be once it takes matters into its own hands.

At this stage, it is the third long overdue cleanse, not a period of sustained and accelerating economic growth, that is the most likely economic fate that lies ahead. And, with global monetary policy makers finally, finally, FINALLY taking their foot off the gas with the People's Bank of China already shrinking its balance sheet, the Fed already raising interest rates and preparing balance sheet shrinking of its own, and both the European Central Bank and the Bank of Japan now actively contemplating their own exit strategies, the likelihood for this eventual cleansing phase is drawing closer in the horizon. It's not here yet. And it's very likely not going to be here within the next six months to a year. But it is still drawing closer on the horizon.

If cleansing over accelerating growth is the most likely outcome, I want to favor the assets that stand to benefit most in such an outcome. This is why I favor bonds over stocks in the long term despite the short term to intermediate-term noise that continues to play out along the way. I own both in the meantime, but I'm a bond lover and a stock hater in the long run until the inevitable cleansing has finally run its course. Then, I will be a stock lover like never before (or at least since early 2003)!

What About The Fed?

Another frequent counterpoint to being a bond lover is the following. What about the Fed raising interest rates? Isn't this bad for bonds?

OK. Let's first answer the question directly and then put some color about it.

Are rising interest rates from the Fed bad for bonds?

Yes, they can be. But it depends on underlying economic conditions while the Fed is raising interest rates. For example, if the economy is experiencing accelerating economic growth while the Fed is raising rates, then yes, money will flow out of bonds in favor of the higher returns potential and greater inflation protection provided by stocks. Then again...

No, it can actually be good for bonds too. For if the Fed is raising interest rates into an economy that is already slowing down (2000) or wasn't really all that strong to begin with (2003-2006, today), then bonds can perform very well.

Now, let's add the color. I always find it puzzling when the question surrounding the impact of higher interest rates is focused primarily on bonds. For it is important to always keep in mind that what may be good or bad for the bond market goose is just as good or bad if not more so for the stock market gander.

Putting this into the context of the current market environment, not only does higher interest rates directly impact the cost of capital and debt servicing costs (remember that debt-to-total capital ratios are running at historical highs today) for firms whose shares trade in public markets but rising interest rates also provide an increasing investment alternative where there otherwise supposedly has not been one for many years (TINA) to U.S. stock securities that now have an earnings yield that has already fallen to historical lows. I know myself, given the opportunity on a risk-adjusted basis to own a security that is backed by the full faith and credit of the U.S. government with a relatively shorter duration given its stated maturity date that is yielding more than a security whose principal value is not guaranteed, whose value is already dear, and whose price volatility is highly unpredictable in its perpetual future path, I'll prefer to own the former over the latter unless the associated organic growth rate with the stock security is that much better. But without a robust economy behind it, such growth rates remain hard to come by.

So, could rising interest rates be bad for bonds? Maybe, but they will probably be more positive than negative given the prevailing economic backdrop. As for stocks? Given currently sky high valuations and the already sluggish economy, quoth the magic 8 ball, "outlook not so good."

Stock H8r

Before moving on with bonds, one final point about being a "stock hater". Yes, I am bearish on the long-term outlook for stocks (NYSEARCA:DIA) for all of the reasons stated above. But I am also short-term to intermediate-term bullish on stocks (NYSEARCA:SPY) also for the stated reasons above. For I fully recognize that monetary policy makers are still in the business of at least maintaining if not inflating stock prices (NASDAQ:QQQ). One has to look no further than the fact that the S&P 500 Index seemingly cannot go down on any given day right now and the CBOE Volatility Index (VXX) remains stuck at historical lows. Stocks did the same thing back in 2006, and it's not late 2007 yet today, so it makes sense to stay long.

What exactly am I staying long? Not the high beta (SPHB) stuff. The quick and relentless market downturn from mid-2015 to early 2016 was a fresh reminder of how quickly high beta can turn and how punishing it can be when the momentum finally dies. Instead, I continue to favor the low volatility (SPLV) side of the market. Fortunately, the stock market is a market of stocks, and I continue to own a number of individual consumer staples (XLP), healthcare (XLV), and utilities (XLU) that are not only holding their own but on a sector basis have been outperforming the broader market for months now since December.

So, while I may be bearish on the long-term outlook for the stock market (NYSEARCA:IVV), I remain a lover of a variety of individual stock names found within the stock market. And, many of these names are those that are conditioned to continue owning even after the next bear market storm finally strikes.

Bond Lover

I have particular love for the bond market right now. And, nowhere is my love more profound at the moment than the long-term U.S. Treasury market (TLT).

Why?

Here are a few reasons beyond what has already been discussed above.

First, bond yields have come off a fair amount since late November. And, while yields have been rallying since December, they remain at the top end of their ultra long-term trading channel dating back to the early 1980s. Given that I like to buy low and sell high, the opportunity to buy Treasuries (IEF), if I wasn't already fully allocated with yields at the top end of a 36-year trading channel, has provided an ideal entry point for the last few months now.

Second, long-term U.S. Treasuries also enjoy well tested technical support levels in its current range. Lately, 10-year yields have been bouncing between 2.25% and 2.50% for good reason, for this is where the current support range lies. And, pressure has been slowly building to push bond yields lower, not higher.

Same goes for 30-year U.S. Treasury yields between 2.75% and 3.25%.

Third, Treasury yields remain on the brink of falling back through the gap that came immediately after the Election when risk assets were suddenly filled with optimism that is increasingly proving unfounded. Looking forward, any sustained move back below 2.20% on the 10-Year U.S. Treasury yields could spark a rally that has yields quickly falling back below 1.85%.

Fourth, the spreads that U.S. Treasuries remain attractive relative to its global sovereign counterparts. While they have come in somewhat relative to Germany since the start of the year, the yield premium received by investors for owning the bonds of the country that owns the world's reserve currency is still most handsome from a historical perspective, particularly since 2011 when things in financial markets first started to really get wonky.

Same with U.S. Treasury spreads relative to Japan, where the 10-year government bond premium remains near historical highs at well north of +2%. Nothing like attractive relative value.

Lastly and bringing the discussion back to stocks, long-term U.S. Treasuries, since the tapering of the Fed's QE3 program began in late 2013, have been moving in lockstep with selected stock market sectors and industries. One such example is utilities, which can be seen in the chart below.

But since early November, the paths for long-term U.S. Treasuries and their stock market counterparts have deviated. And, given that the economic backdrop has not meaningfully changed despite the hopes of many over the past several months, it is likely that these two paths will reconverge at some point in the future. And, while I also own a number of utilities including Southern Company (SO), the more favorable side of this trade from a risk-reward standpoint is owning Treasuries at the present time.

The Bottom Line

I remain bullish on bonds for a variety of reasons. And, the last several months have and continue to provide attractive entry points, particularly in longer-term Treasuries, for those either directly interested in the bond market or actively seeking a true diversification benefit for their stock portfolios.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Eric Parnell, CFA