COLUMN-Stocks from Venus, bonds from Mars: James Saft

(James Saft is a Reuters columnist. The opinions expressed
are his own)

By James Saft

HUNTSVILLE, Ala, August 16 (BestGrowthStock) – Forget about
politics, the biggest divide in the U.S. is between stock and
bond investors, who aren’t so much arguing as speaking entirely
different languages.

Stocks, while about flat for the year, are priced
moderately cheaply by historical standards, implying that
investors think they have a reasonable, if not spectacular,
outlook for the next couple of years.

Earnings are strong, and forward looking estimates of
earnings, while coming somewhat off the boil, are still rosy
and cash balances are high.

Bonds, in contrast, are telling you that the U.S. will be
dicing with deflation and recession over the same period,
painting a landscape in which the great thing is to hang on to
your capital.

Check this out: The yield on a ten-year U.S. government
bond is 2.58 percent while the S&P 500 has an earnings yield,
measured on a standard accounting basis, of 6.23 percent.

Somebody, to put it mildly, is going to end up
disappointed.

There is simply no way that earnings can stay that high
relative to stock prices while bond yields stay that low. If
the earnings can be sustained, stock prices will rise. If that
scenario plays out, here’s betting the whole deflation and
recession thing has given way to either moderate growth and
even possibly inflation.

If so, you will not want to be one of the people who two
weeks ago bought a three year bond from IBM that yields —
wait for it — 1.0 percent or the kind of coupon that makes you
think Mr. Roosevelt must speaking on the wireless again.

Nor, if the stock market proves more right than wrong,
will you want to be one of the people holding AAA non-financial
debt, which now yields 4.72 percent, the lowest in almost 45
years.

So, are bonds in a bubble and should investors reverse
course and re-allocate to stocks?

Probably not. The bond market is not in a panic and the
kinds of returns being generated are not the kind we usually
associate with speculative frenzy. In fact the one real scene
of frenzy in the bond market is in high-yield, or junk bonds,
where issuance is positively booming.

Interestingly, though as borrowers are jumping over each
other to sell high yield bonds, they are doing it into a market
that is requiring them to pay a heck of a lot in interest for
the privilege.

Despite the fact that high-yield defaults are less than
half their historic average, the yield spread on junk bonds
compared to U.S. Treasuries is about 60 basis points wider than
their average over the past 12 years, according to BNP Paribas
Asset Management global credit strategist Martin Fridson, who
said the discrepancy is signalling about a one in four chance
of a recession.

TIPS OF THE ICEBERGS

A look at the market for Treasury Inflation-Protected
Securities (TIPS), bonds which pay more or less based on actual
consumer price inflation, underscores the extreme disconnect
between stocks and bonds

The real yield on ten-year TIPS is only 1.0 percent, while
five year TIPS yield essentially zero and three-year TIPS have
a negative yield.

If those yields come anywhere near to reality, it will be a
very fine company indeed which can produce competitive returns
for its stockholders.

TIPS are implying, at best, that there is absolutely
nothing to fear from inflation and at worst, that we are
heading into a period of deflation and a sustained period of
very low growth.

Jim Leviss, a bond fund manager at M&G in London notes (
http://www.bondvigilantes.co.uk/blog/ ) that TIPS contains two
features that are extremely valuable under current
circumstances.

Though real yields on TIPS are extremely low, investors
always get back 100 cents on the dollar, even if inflation
turns negative and those 100 cents are growing in purchasing
power, making it a hedge against deflation. At the same time,
TIPS, by their nature, offer protection against inflation,
which many believe could get out of control if the Fed is
forced to take more desperate measures.

Analyzing the meaning of the bond market is a heck of a lot
more difficult now, however, for the simple reason that
quantitative easing is distorting its message.

As the Federal Reserve buys government bonds they
artificially lower what we used to think of as the risk-free
rate. This is intended to induce us to take on more risk in
order to revive the economy, but it might also make government
bonds give artificially gloomy signals while other risk assets
are made artificially cheerful.

In the end, the stock and bond market may well split the
difference, but, as always, it pays to apply a heavy discount
to almost everything you are told about stocks by all of the
people whose livelihood depends on you confusing your own best
interests with theirs.

(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. For
previous columns by James Saft, click on [SAFT/])

COLUMN-Stocks from Venus, bonds from Mars: James Saft