Newsletters 2009 Newsletters Who Will Blink First? (10/21)
Wednesday, 21 October 2009 16:09
Just like the Energizer Bunny, the recovery rally in the stock market keeps going and going. Despite September’s historical track record as the worst performing month of the year, the S&P 500, Dow Jones Industrial Average and NASDAQ Composite rose 3.57%, 2.27% and 5.64% respectively. These important barometers of the market are now up 17.03%, 10.66% and 34.58% respectively through September.
In last month’s newsletter, we pointed out that the bond market seems to have shrugged off the potential threat of higher inflation, even as the dollar weakened, gold reached new highs and commodity prices continued their recent ascent. As indicated, we remain vigilant about what these trends may be telling us and will keep you apprised of any clues. Indeed, it seems that the fixed income and equity markets are telling us polar opposite stories about the economy and both, it would seem, cannot be right.
The markets are well aware that the Federal Reserve has played a substantial role in keeping interest rates low by expanding its balance sheet, buying both Treasuries and mortgage-backed securities. Recent data reveals that the Fed has purchased $293.2 billion of U.S. Treasuries and a whopping $818.4 billion of Agency debt thus far. With the financial and economic crisis fueled by the massive deleveraging of both businesses and consumers alike and rampant fear of a deflationary spiral, the Fed has helped engineer a massive opportunity for America to refinance at historically low rates, thereby softening the blow that deleveraging might otherwise have caused and helping clean up our collective balance sheet in the process.
In addition to the Federal Reserve’s efforts, foreign central banks have purchased just under $400 billion of U.S Treasury debt this year. According to the International Monetary Fund, non-gold international reserves held by central banks rose to a record $7.36 trillion as of the end of July. Of this $7.36 trillion, $4.7 trillion or 64% is held by emerging nations. With massive and growing reserves, it is not surprising to see foreign central banks invest a small portion of their reserves in Treasuries, despite all the rhetoric and fear to the contrary.
What is surprising, and perhaps telling of things to come, is the extent to which inflows into bond mutual funds has dwarfed that of stock funds this year. Of the $273.2 billion invested in mutual funds for 2009 through the end of September, only $3.8 billion or 1.39% of inflows has been invested into stock mutual funds! That leaves the other $269.4 billion of net mutual fund inflows pouring into bond funds, even as yields on Treasuries reach historic lows.
Today, 5-year bills, 10-year notes and 30-year bonds offer respective yields of 2.387%, 3.47% and 4.313%. As low as these yields are, money market fund yields are even worse, yielding less than 1% for the first time since they were first introduced in 1971. With $3.4 trillion still sidelined in money market funds, we can appreciate that investors have grown tired earning next-to-nothing on their substantial cash. However, given the significant recovery in the stock market and paltry yields on safety, one might have expected a much higher allocation of inflows into equity mutual funds. Not only has this not been the case throughout the year, mutual fund investors actually pulled $12 billion out of stock funds in August and September. And year over year, incorporating the panic sell-off of last Fall, these trends are even more staggering with $156.69 billion of net inflows into bond funds and $156.79 billion of net outflows from equity funds. Given the sharp recovery in stocks, one might have expected that retail investors would be chasing the rally and helping drive the market higher with fresh purchases into strength. The fact that this is not happening is testament to how severe the crisis was and how fearful investors have become.
Having missed the rally thus far, the dry powder represented by the average retail or mutual fund investor remains an important source of future buying power for equities. Moreover, especially since bond funds have no maturity as individual bonds do, we can almost hear the stampede out of bond funds that is sure to result once the Fed decides it’s time to tighten. By definition, the Fed Funds rate cannot be lower than zero and so the next move by the Fed must be a rate hike. There is much debate about when the Fed might finally consider raising rates, with the Fed Funds futures pricing in 100% odds for a 25 basis point hike by June 2010, even as many economists argue that the Fed will remain idle until the end of 2011. Whenever the Fed ultimately pulls the trigger, Bernanke and company have already telegraphed that they will move decisively, leaving the impression that current accommodations will be taken back in greater increments than the quarter-point-at-a-time Greenspan Fed. Given the downward pressure on the dollar, rising gold and commodity prices and earnings and economic news that continues to beat expectations, we would not be surprised to see the Fed begin the tightening process by the April meeting of the Federal Open Market Committee.
The combination of Federal Reserve intervention, foreign central bank diversification of reserves and massive retail inflows into bond mutual funds have all helped contribute to keep interest rates at very low levels. In a “normal” environment, the decline in Treasury yields would almost certainly point to concerns about economic growth. Yet the steepness of the yield curve, rise in the stock market, gold and other commodities are telling a different story. One could make the case that just as excessive liquidity is driving down yields, so too is that liquidity driving up stock prices. In the end, it would seem that hindsight will prove one of these two asset classes to be priced too high and ultimately “wrong”.
We know that the Federal Reserve has telegraphed its intentions to gradually slow its intervention in the Treasury and Agency markets, thereby removing one leg of the Treasury inflow stool. We know that the Fed is considering draining liquidity from the system through the use of “reverse repurchase agreements” and other mysterious measures. We know that the next move by the Fed will be to hike rates and we know that mutual fund investors have poured money into bonds, not stocks. We further know that the Obama Administration anticipates ballooning multi-trillion dollar deficits for the next decade, guaranteeing a growing supply of Treasury debt even as the “artificial” but necessary demand from the Fed is removed. In light of all this, we can’t help but think it more likely that the liquidity “sugar rush” has been to the particular benefit of bonds, not stocks, and it will be the bond investor left without a chair when the Fed’s music stops playing.
So, who will blink first? Will the Fed surprise investors with an earlier than expected rate hike? Will foreign central banks, fearful of a continued slump in the dollar, temper their purchases of Treasuries and demand higher interest rates? Will mutual fund investors finally find the rising equity market too tempting to pass up? And where have all the bond vigilantes gone? A wave of selling by the so-called bond vigilantes is a more likely outcome than outright selling of bonds by foreign central banks, in our opinion, and could very easily force the hand of both the Federal Reserve and mutual fund investors alike. Any of these potentialities in their own right do not bode well for the bond market.
We are tempted to call Treasuries a “bond bubble” in the making, yet high unemployment and low capacity utilization present sufficient economic slack to give us pause as to the durability of the recovery, especially with a less accommodative Fed, increased government regulation and the potential for higher taxes on the horizon. We remain in the “new normal” camp and believe these headwinds will make it more difficult for the economy to reach its full potential. With the likelihood for rising rates in an environment of below-trend growth, the appeal of high-quality growth companies that can deliver predictable earnings growth and consistent dividend increases should increase measurably. When investors finally pull the plug on bond funds, it is highly likely that a good portion of subsequent proceeds will find their way into equity funds that provide steady dividend income and, importantly, growth of income.
Standard & Poor’s just revealed that only 191 out of the approximately 7,000 publicly owned companies that report dividend information to S&P increased their dividend during the 3rd quarter, making it the worst 3rd quarter ever for dividend increases. And 113 companies actually decreased their dividend during the 3rd quarter, the highest number of dividend decreases since the 3rd quarter of 1982. Meanwhile, Osher Van de Voorde core equities are set to deliver approximately 7% dividend growth in 2010 after increasing dividends by an impressive 9% in 2009. Further, S&P’s data reveals that since 1955, dividend increases have outnumbered dividend decreases by a margin of fifteen increases for every one decrease. This year, the margin for increases to decreases is close to a one-to-one relationship. In contrast, we are very proud to boast that 91% of Osher Van de Voorde core equities pay a dividend (cash rich Berkshire Hathaway and Cisco are the exceptions) and 95% of our dividend payers are expected to increase their dividend in 2010.
Perhaps the decision as to which asset class will win the bond-equity tug-of-war can be found in comparative valuation. Consensus earnings estimates for the S&P 500 are now $75.57 for 2010 and $92.92 for 2011, implying a 2010 forward PE of 14 and a 2011 forward PE of 11. With an approximate 2.25% dividend yield for the S&P 500 at present, proximate to the yield on 5-year Treasuries, and equity valuations relatively attractive in such a low interest rate environment, the time would seem right to favor equities. If we apply a reasonable PE of 15 on 2011 expected earnings, the S&P 500 would rise to 1380, an increase of approximately 26% from current levels, within the next couple years. That’s a story worth reading.
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