“The portfolio of half stocks and half bonds…is the worst ever” … Cliff Asness told Tyler Cowen on Nov 18, 2015. His reason is that fundamental measures of stock and bond prices indicate that they are both very expensive. Why? A shrinking pie at the same time everyone wants a bigger slice.
Vanguard is the poster child for buy and hold. So when their top strategist and head of fixed income start issuing warnings about low returns in stocks and sticking with “safe” assets like bonds, I pay close attention. The problem is quite simple. Investment prices are very high relative to fundamentals. Vanguard’s founder, Jack Bogle, told the WSJ that investors will be “lucky” to achieve 2% (minus expenses) over the next 10 years. Mr. Bogle’s US stock return forecast is based on the cyclically adjusted price to earnings ratio (CAPE). The CAPE takes the fun out of PE by using a simple 10 year average of earnings rather than the past year or next year’s forecast. This turns out to be quite useful because last year’s earning may be an anomaly and analysts have a poor track record of forecasting future earnings.
Some argue that the CAPE is overly conservative because changes in accounting rules have led to lower reported earning; which make PE ratios appear higher. Others argue that using historical US stock price returns is aggressive because both the world and the US are growing more slowly. Both arguments are reasonable although it’s difficult to say whether one out weights the other. To gain more comfort with CAPE I’ve also provided Warren Buffet’s preferred measure of stock market capitalization to GDP. They tell the same story… there is little upside and a long way down.
At what point would stock returns become too low to be worth the risk for even the most risk friendly of investors? The chart on the right shows the average returns and probabilities of price drops for values of CAPE. These are based on historical S&P 500 index values, earnings and dividends. Higher values of CAPE reduce expected return and increase the probability of a large drop in prices. These statistics suggest that when the CAPE is at or greater than 27 a patient and disciplined investor can do as well or better than the S&P 500 by holding some low yielding money market funds and waiting for the drop. We are at 26.86.
As expensive as stocks are, many bonds appear to be in a genuine bubble. The term “bubble” gets tossed around a lot so let me be clear on this point. Analysts and academics typically define a bubble as any asset that has: 1) a run up in price, 2) diverged from fundamentals, and 3) is bought by “enthusiastic” investors who appear to have gotten carried away. The problem with this definition is that it describes Google, Microsoft, Amazon, and many other pricey companies that have remained expensive for many years. Instead, I am going to define bubble the way Cliff Asness defines a bubble: when an asset class is priced so high that it cannot be justified by any reasonable scenario. This is a much more stringent criteria for the term bubble, because it removes the possibility that prices can remain high.
In my view, Sovereign bonds fit this definition of bubble. These “risk free” assets with maturities of 30+ years have MtM gains YtD of 15-50%, exceeding nearly every other asset class. The reason may be the most talked about financial concept of the year, negative interest rates, which according to “The History of Interest Rates” by Sidney Homer and Richard Sylla has never occurred. Let that sink in for a moment. Not once, in the past 5000 years, have humans ever lent money at a negative interest rate.
Many investors fail to appreciate just how risky “risk free” sovereign bonds with little to no coupon can become. A 6% coupon bond will lose 30% of its value if rates rise by 3%. This would be substantial, but today’s near 2% bonds would lose over 40% from the same shock. Japanese government bonds (JGB) issued at near zero rates would lose 60% of their value. Why aren’t more JGB investors running for cover now that the BOJ has doubled down on attempts to spur inflation? More on that in future observations.
Corporate bonds may also be in a bubble. Some European corporations are now getting paid to borrow money. This is a truly extraordinary development as corporate bonds obviously contain credit risk. However, we can’t jump to this conclusion by looking directly at the yields. Corporate bonds are priced off of sovereign bond yields so pointing out low yields in corporate bonds would be redundant. Instead, let’s look at their option adjusted spreads (OAS).
Treasury bonds are unique because they are the most liquid bonds in the world and are generally believed to have next to zero risk of default. For this reason, other bonds yields are often viewed in terms of their relative yield to the Treasury bond spot curve or OAS. Even after removing the general down trend in Treasury yields, corporate bond prices are still very low in the United States across risk grades and maturities. The same pattern can be seen other industrialized countries and emerging markets.
What this means is that there is very little room for yields to cover losses from defaults. Take for instance United States corporate bonds (left). Today, spreads are quite low at only 2% above treasury yields. Some of these corporates will inevitably default. At the historical average charge-off rate of about 1%, that will leave investors with only 1% above Treasury bond yields of comparable maturities. However, if we experience even a minor recession like that of 2001 the OAS would likely be completely wiped out. Meanwhile, the average maturity on corporate bonds has doubled in the past 15 years. Remember what I just wrote about sovereign bond duration risk? That applies here as well, but not quite as serious because corporates generally pay a higher coupon.
The most disturbing thing about corporate bond spreads is that just in the past year they have become unresponsive to increasing default rates. Historically, any increase in default rates send yields higher, and fast. This year, rates have been mostly down or flat. Bonds are also starting to move more with stocks, reducing diversification benefits.
The reasons behind these developments will be the topic of future observations. In short, more cash is chasing fewer financial assets, bidding up prices. This is happening at the same time that global growth (the pie) is slowing. What this means is that we should probably be more pessimistic than historical relationships between asset prices and fundamental might lead us to believe.
Be careful with “alternatives” to stocks and bonds. You are not the only one who has been looking.
Feel free to share your own thoughts on the stock and bond price fundamentals. There is no better compliment you can give us than your thoughtful criticism. You can reach us at email@example.com, or follow us on Twitter @intuitecon
Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.