Stampede in Stocks and Bonds


Check any Investing 101 textbook, and it will tell you that stock markets and bond markets are not supposed to both be on the rise at the same time. Yet that's exactly what's been happening lately.

Stock and bonds have been behaving like two herds of bulls, and, as they used to say in the Old West, "there ain't room for two bulls in the corral."

Capital markets have shown the power of both bulls in the last quarter, with the S&P/TSX total return index up 10.6 per cent in the 90 days ended June 30 and the Scotia Capital universe bond total return index up 5.1 per cent in the same period. For stocks, where financial optimists roam, and bonds, where pessimists await better times, this raises the question of who's in charge at the ranch.

Both herds of bulls can't be right -- either we're in for hard times that imply a worse stock market and a better bond market, or good times, which imply a continuing stock recovery and declining bond prices.

The lack of consensus in the market about which way the economy is headed creates headaches for investors trying to determine how best to allocate their money in their portfolios.

For investors, betting on the right bull is vital. It's a question of where to put your money and that's a matter of asset allocation. That's one of the most important determinants of return in investment planning, says Derek Moran, a adviser in Kelowna, B.C., with fee-only financial planning firm Macdonald Shymko & Co. of Vancouver. Among the three financial measures used in conventional asset allocation -- equities, debt instruments and cash -- the debt-to-equity ratio of a portfolio is a vital determinant of its risk and return, he says.

"Cash is earning next to nothing in bank accounts and slightly more than nothing in GICs [guaranteed investment certificates]," he says. "Investors are under pressure to choose between stocks and bonds."

Analysts doubt that the trend of strength in both markets can continue.

"There is a contradiction in bonds and stocks both being strong at the same time," explains Sal Pellettieri, senior quantitative analyst at IG Investment Management Inc., the portfolio management unit of Investors Group Inc. of Winnipeg.

Stocks and bonds have been so bullish that "both markets are overvalued now," Mr. Pellettieri argues.

In the United States, rising stock and bond markets hit a short-term peak at mid-year with the Standard & Poor's 500 composite index up 10.8 per cent over six months ended June 30, and a broad measure of U.S. bonds, the Salomon Bros. U.S. corporate bond index, up 8 per cent in the same period. Improving business prospects usually boost corporate bonds, but it is the big picture that's of interest.

Of the two markets, it looks like the bond market has blinked first.

In June, financial managers took note of the negative view of the U.S. economy prevailing in the bond market, which was trading U.S. Treasury 10-year debt at a yield of 3.15 per cent. Recently, they sold bonds down to a 4.2-per-cent yield on 10-year U.S. Treasuries. (Yields rise as bond prices fall, and vice versa.)

"A 100-basis-point move in interest rates in just one month is very big," says Clément Gignac, chief economist at National Bank Financial in Montreal.

"Not since 1987 has there been such a big selloff" in bond prices.

Bond prices fell, with the result that yields rose, but bonds remain a measure of future expectations. And even with the rise in yields in the past month, bond yields continue to portray a fairly pessimistic view of future investment returns. At 4.2 per cent a year for a decade in a federal bond with no credit risk, the implication is that bondholders are accepting an economic environment in which it will be hard to make much more than that -- at least without taking on additional risk.

As bonds were being sold this month, money was moving to stocks. But this recent shift out of bonds and into stocks might be short-lived, experts suggest.

Some analysts doubt that there will be a continuation of the stock market recovery that has seen the S&P/TSX 60 total return index rise 9.8 per cent in the three months ended June 30 and the S&P 500 leap 14.9 per cent in the same period, suggests David Adamo, who heads fixed income research at Scotia Capital in Toronto.

"The odds are that this stock market rise will not run much further," he says. He expects that corporate profit growth will stall in the summer, equity prices will fall and money will head back to bonds.

The standoff between stocks and bonds could be decided by the way the U.S. government chooses to finance its nearly half-a-trillion-dollar war deficit, and by what China does about its immense trade surplus with the United States. The Chinese trade surplus amounts to a quarter of the entire U.S. trade deficit, Mr. Gignac notes.

For China, that surplus loses value as the U.S. dollar, to which the Chinese currency is pegged, declines. As Mr. Gignac sees it, what happens in China will determine the outcome of the stock and bond standoff.

If China yields to U.S. pressure and revalues its currency, then Chinese exports will rise in price. U.S. manufacturers that have been restrained by Chinese products that compete with their own goods will be able to raise their prices, and there will then be growth in revenues, Mr. Gignac says.

Rising prices will put an end to deflationary fears. If product prices start to rise, inflation will return and 10-year U.S. Treasury bond prices will have to fall to produce a yield of around 5 per cent, which he regards as their fair value. Right now, Mr. Gignac notes, a 4.1-per-cent annual yield on a 10-year bond only produces a real return of 1.6 per cent above assumed inflation of 2.5 per cent for the next decade. "That's no way to get rich," he says.

Over the next few months, many market watchers take the moderate position of Rick Howson, executive vice-president of Howson Tattersall Investment Counsel Ltd. of Toronto, a pension fund and mutual fund manager.

"Bonds are overvalued and they will drop in price when there are solid signs of recovery in the U.S.," he says. "But that will be a moderate bull market. And in Canada, the recovery will be restrained by the strength of the Canadian dollar." At present, however, stocks seem anything but cheap and ready for a zoom upward.

"Stocks are overvalued no matter how you slice it," says Patrick O'Toole, assistant vice-president for investments at Mackenzie Financial Corp. of Toronto. "Stocks are selling for 50 times dividends, and a low where recoveries occur should price stocks at only 15 times dividends. We are not ready for that recovery."

In the near term, Mr. O'Toole expects profits to rise faster than stock prices. In other words, corporate performance has to catch up to stock prices before the market can continue the blazing pace it set in the second quarter.

He doubts that this will happen quickly, however. His reasoning is that, unlike former recessions that hurt the consumer as much or more than investors, this time there is no pent-up demand for housing or cars.

Still, with all that in the balance, Mr. O'Toole says the remainder of 2003 will belong to equity investors.

"For the rest of 2003, stocks will beat bonds," he says. His recommendation is to be cautious.

Mr. O'Toole predicts that for the next five years, annual stock returns should be in a range of 6 to 9 per cent, compared with about 4 to 6 per cent for bonds. But when you add volatility to the equation, then, on a risk-adjusted basis, bonds are going to run neck and neck with stocks, he says.

"The tech bubble taught everyone that a portfolio tilted heavily toward stocks carries excess risk that most folks can't stomach," Mr. O'Toole says. "Under the circumstances, conservative investors should aim for a 50/50 split between stocks and bonds, and vary from it depending on how much they need steady income, which would raise the bond allocation, or how much they want long-term gains, which would raise the stock component."

"Keep a diversified portfolio," he urges.

Like many other analysts, he says this is no time to bet the ranch on either the bond bulls or the stock bulls.

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