Which Way Will Stocks And Bonds Go?

It is cash that is going to be the big winner when its owners (take) the opportunity to reenter the market when things have cooled a bit.

U. S. and Canadian stock markets have recovered most of the ground they lost in the bust of 2008. Around the world, there has been a surge of investment activity. The MSCI World index of share prices around the globe is up 70 per cent over its March 2008 lows. Closer to home, the small cap TSX Venture Composite Index rose 90.8 per cent in 2009. Investment analysts say that share prices will continue to be driven by improving corporate earnings. What’s more, a return of investor confidence should push up ratios of price to earnings, giving the market a kind of positive double whammy. This is a best case scenario — the “what goes up will go up further” argument. It is also a bet on momentum in the face of the odds that what has gone up a lot is just as likely to head down for a while.

It’s not just the stock market that is soaring. In Canadian residential real estate, sales of existing homes in December, 2009 rose 7.7 per cent over the same period a year earlier, according to the Ottawa-based Canadian Real Estate Association. For now, the decline of housing prices in Canada is over. More importantly, the average sale price of a home climbed almost 103 per cent over the past decade, compared to about a 40 per cent increase for the S&P/TSX composite index in the same period. By comparison, the average house price increased just 8.0 per cent during the 1990s.


The boom in financial assets is not the result of recovery in the underlying economy, where official unemployment rates — 8.4 per cent in Canada and 9.3 per cent in the U. S. — are at multi-decade highs and where unofficial unemployment is probably twice those numbers. No, this boom is the handiwork of central banks keeping short-term interest rates near zero.

Low interest rates are mischief makers. They can and indeed have helped banks and their business customers recover from the liquidity crisis of 2008, but now they are forcing investors who want a significant return over, say 1.0 per cent on cash, to buy risky assets. The riskier the asset, the more it has risen. So the question has to be asked: When the Bank of Canada and the Federal Reserve, the Bank of England and the European Central Bank start raising rates, will the speculative house of cards come tumbling down?

This is not a case of potential market hysteria. It is quite real. A significant move upward in short rates, which the credit market has already anticipated by raising yields on bonds with maturities over two years, would force companies to pay more interest on their loans and drive speculative investors to sell assets in order to pay down their loans.

Who would lose? Investors who are less nimble than the institutional traders, who will be first to sell. Those traders know

that, in an effort to keep inflation as measured by the consumer price index (CPI) down, central bankers have created asset price inflation.

Back on Main Street, the price of a can of tomato soup is not much more than it was in 2008. But shares of a big tomato soup company, Campbell’s in this

case, are up 45.3 per cent in the last 12 months. The world is not lapping up that much more soup, but investors are willing to cough up a premium price in this market in which even a rather dull consumer products company seems tasty.

We are at a point of decision or, if you like, indecision. As the January 18 issue of The Economist, a British newsweekly, reported, interest rates set by central banks will stay low only if growth remains low. If that happens — in other words, if the recovery falters — then profits will not go up and stock prices will come down. Income will also stagnate and house prices will tend to sag. If, on the other hand, markets are right about the prospects for economic growth and the underlying economies continue to recover, the governments will tend to cut off the supply of nearly free money. That move will also curb share and house prices.


The most important thing is to realize that we are in a period of high asset price inflation driven by artificially low interest rates. Government bond prices have nowhere to go but down. Ditto investment grade corporate bond prices. Convertible bond prices would do well if the recovery continues, even if interest rates do rise a bit. (I talked about these in my bond column in the February 22 Grainews). But it is cash that is going to be the big winner when its owners, waiting for the opportunity to reenter the market when things have

cooled a bit, pick up stocks with lower prices and higher dividend yields, bonds with higher yields, and investment funds of all sorts that are ready to generate higher returns off of reduced entry prices.

One of the best bets in the process, in which speculative markets take a breath and return to reality, could be real return bonds (RRBs) that are priced to rise or fall with the rate of inflation. RRBs pay a low interest rate, about 1.5 per cent, and then add inflation as measured by the CPI. RRBs are now pricing in CPI inflation at 2.5 per cent. If CPI inflation were to rise over 2.5 per cent for a period of a year or more, RRBs would pay a premium to owners.

RRBs have, in fact, thrived on unexpected gains in inflation over the last decade. For the 10-year period ended Dec. 31, 2009, mutual funds that specialize in RRBs gained 7.04 per cent per year compounded annually compared to mutual funds that have conventional bonds that gained five per cent compounded annually for the period. For the year ended Dec. 31, 2009, RRB funds gained a spectacular 13.64 per cent compared to the 6.21 per cent gain in conventional bond funds. The performance gap is not going to be sustained, but the point is clear — betting on inflation is a good deal.

The reason a bet on inflation may work is that, simply put, governments have already allowed a lot of inflation to happen. Some of the higher prices of financial assets that have been puffed up by artificially low interest rates will leak into the real economy. Higher prices of machinery will eventually drive up the CPI and, with that, the prices of RRBs that are set on moves in the CPI. (For more on RRBs, see my column in the January 25 Grainews).

A word of warning: The Department of Finance treats all gains in RRB prices as interest. Calculating RRB gains is complex as well. But if you hold RRBs in a registered account like an RRSP or a Tax-Free Savings Account, you have no bookkeeping worries.

Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life After Work, was published in 2009 by Viking Canada.

About the author


Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.



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