As a stock research house, we always look over our shoulders at what our bond cousins are up to. Not that this has any bearing on our ratings, of course, but out of sheer interest in the pricing correlation between bonds and stocks. This is especially true when certain “safety” bonds are a proxy for investor fear as has been the case with uncertainly about the viability of the Euro, the latest banking crisis in Spain, and global equity markets heading south.
Yet, for a bond investor, nothing chills more than the thought of being invested when yields start heading north. And when cash carries nearly the same return premium as investing in Treasuries with real negative returns for each after the rate of inflation, then watch out! Even being in cash may not be the wasting asset we were all taught that it was – especially when you consider that capital losses accompany any bond rally.
Bonds in the United States, Japan, and Germany are more expensive than they have ever been at any point in history. Bond investors especially those invested long – term will surely face losses. By keeping rates low, the United States is reducing the burden of debt and restructuring it on the backs of bondholders. Witness all the pre-payments just with HARP mortgage program alone. Investors receiving them have no choice but to reinvest at lower rates. According to Burton Malkiel, Professor of Economics at Princeton, the United States reduced its ratio of debt to GDP from 122% in 1946 to 33% in 1980 – all at the expense of bondholders.
Equities on the other hand are cheap when compared with current bond yields and the potential for capital losses. What will it take to shake off the excessive pessimism investors have about equities is anyone’s guess. And although equities certainly do present downside market risks, it is a mistake to concentrate only on the downside. It is also worth noting few investment classes remain as tradable as equities do in public markets – enhancing their appeal as an asset class. University endowments, for example, that invested heavily in private equity and real estate in the early 2000s are still struggling with illiquidity.
To quote John Campbell, a professor of economics at Harvard University: “ For a well diversified long-term investor, stocks are not bargain priced today but they do offer significant compensation for their risks.”
In this sense, among asset classes, equities may be the best of a bad bunch.