Stocks Are Cheaper Than Bonds, And Other Falsehoods
Summary Currently, the crowd continues to advance the notion that stocks are the only investment to be considered, despite the overvalued condition in risk assets. The notion that bonds are overvalued and underperform stocks, and that cash is earning 0% is also advanced by the crowd. In reality, cash and bonds offer investors tremendous value in a world of declining economic growth. This is especially true given that the economic risks are rising. Stock Market Valuations within the Context of Global Economic Instability: Implications for Portfolio Construction Stocks are cheaper than bonds, or so we are told by the crowd which was out in full force again for the September FOMC meeting, calling for a rise in interest rates, despite the fact that we have not met any of the conditions for such a rise in rates. One of the major reasons investors, and more specifically savers, have for why the Fed should raise interest rates is the notion that cash is currently earning close to 0% on savings, and money market balances. However, when viewed within the context of the global economic environment, and when we take into account the impact of a rising dollar on purchasing power, cash is providing investors with a very nice return. In a previous piece , I explored the reasons behind holding cash. As risk asset prices have risen to lofty levels, investors are far better, in my opinion, holding a majority of their assets in Zero Coupon U.S. Treasury Bonds and cash. The Global Economy and the Rise of Deflationary Forces Why would I pursue a strategy of largely abandoning risk assets for fixed income and cash? For several reasons: 1. CAPE valuation The first reason is valuations. Valuations in the US are trading at levels that are more than 53% above its arithmetic mean and 65% above its geometric mean, as seen in the charts below. As the earnings season begins, the street is expecting a 4.6% decline in S&P earnings. I would contend that this is far more modest than what the actual numbers will turn out to be. The strong dollar continues to be a headwind, as is the decline in overall demand. This, combined with the complete decimation of the commodities complex , declining fundamentals in the global economy, and a FED that keeps the markets uncertain will likely lead to a severe drawdown in risk assets. In such an environment, cash and Zero Coupon U.S. Treasury Bonds are excellent investments. (click to enlarge) (click to enlarge) 2. The Real Yield on Cash The U.S. dollar has been rallying in the face of rising deflationary forces globally. Over the past three years, the U.S. dollar has soared 14.6%. I expect further economic weakness, and growing challenges overseas, combined with extraordinary monetary policy from the BOJ and the ECB will drive the US dollar higher relative to the yen and euro as well as other foreign currencies. As the value of the dollar rises, so does the buying power of Americans cash balances, making the real yield on cash much higher than the current minimal rate of interest. 3. Deflationary Forces and Tepid Economic Growth The challenges overseas are well documented. Japan remains in an economic malaise, even as Abenomics attempts to bring it out of the doldrums. The eurozone remains entrenched in an extremely slow-growing economic environment on the verge of recession, with deflationary forces rising. Canada is currently in recession, and in the United States, many try to make the case that the economy is doing just fine. But the reality is that the economy is a patient in need of ICU classification, as the charts below will indicate. The labor force participation rate is at its lowest level since 1978. (click to enlarge) To those who believe this is largely caused by the retirement of the Baby Boomer generation, the next chart will be particularly useful in dispelling this idea. (click to enlarge) Falling industrial production and ISM Manufacturing (below) are not indicative of an economy running on all cylinders. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) The data point that I find most concerning is the complete collapse in velocity to the lowest levels in more than 50 years. Despite the Fed’s massive QE program, velocity has continued to decline. (click to enlarge) Implications for Portfolio Construction The world is currently on the verge of a recession . Conventional investment planning has largely failed to protect client assets multiple times in the 21st century, largely due to its reliance on risk assets for the majority of client capital. I believe in a more conservative approach that protects investor capital through a complete investment cycle. On February 18, 2013, Dr. John Hussman wrote an excellent commentary entitled ” The Sirens Song of the Unfinished Half-Cycle ,” in which he explains the overvaluation of the market and the likely drawdown that will result in the completion of this market cycle. (click to enlarge) Since Dr. Hussman wrote this commentary, valuations have only extended further, making the current conditions all the more unstable. These are not conditions in which I would, in good conscience, be overweight risk assets. Especially that which is needed for retirement, regardless of age. I believe capital preservation is the key objective, and I am willing to miss excess gains on the upside when the market gets expensive, rather than be exposed to a severe drawdown due to speculation in an overvalued market. As we seek to preserve capital, cash and cash equivalents (Treasuries) appear to be the best investment vehicles in a world of slow economic growth with rising deflationary and recessionary risks and overvaluations on risk assets that make future returns minimal. While the equity risk premium has already been debunked , the future will likely give us a further case study. One thing I have learned in my decades of investment experience is that the habits of successful investing are often contrary to common human behavior. This is why we seek to ignore the crowd and the noise that accompanies them. I have been writing about our extensive exposure to U.S Treasury bonds for some time. Currently, Treasury bonds are one of the most vilified assets around, and yet, from 2008-2015, long-term Zero Coupon U.S. Treasury bonds have returned 107.91%, while the S&P 500 has returned 64.89%. During this entire period of time, the crowd was vilifying Treasury bonds and telling investors to favor equities. In this case, following the crowd would have cost you a 43.02% gain. Conclusion While many investors and savers may be frustrated by the lack of interest they are earning on their cash balances, the buying power of their cash continues to rise as the value of the US dollar increases. In this environment, cash and cash equivalents are king, and as major headwinds from global growth concerns and U.S. dollar strength, among other factors, begin to reduce the earnings power of U.S. companies, the market will correct in tandem. Additionally, we face continued market uncertainty surrounding monetary policy and the possibility of a government shutdown later this year, which could cause additional stress on the market. I continue to feel comfortable with the majority of our assets in cash and long-term Zero Coupon U.S. Treasury securities as well as select short positions, with an underweight in equities, favoring cheaper-priced foreign equities over those of the expensive U.S. market.