It is a dilemma unique to the times, specifically to January and February 2014. After a remarkable run from 2011 or, for that matter, from the beginning of the recovery in March, 2009, stock markets in Canada, the U.S. and in much of the world are breaking through former highs.
The broad U.S. market measured by the Standard & Poor’s 500 Composite was up 38.3 per cent for calendar 2013 in Canadian dollar terms. Take off eight per cent for the currency gain and the index did a remarkable 29 per cent leap. That’s on top of 13.5 per cent in Canadian dollar terms for 2012 with no significant currency appreciation. The combination of the two years is 42.5 per cent. It doesn’t get much better than that. Now the question is whether the U.S. stock market, which is the bellwether for the world’s equity markets, can do it in the remainder of 2014.
In early 2013, faced with low fixed income returns from bonds, GICs and savings accounts that barely matched inflation, stock dividends and potential capital gains looked good, so investors piled into equities, driving up their prices. What they were really doing was paying ever more for expected profits. In market terms, the p/e ratio of price to earnings rose from about 21 in early 2013 to 25 in January 2014. That gain has created a dangerous place to be.
The U.S. stock market’s multiple of expected earnings is well above the historical average of about 17 times next year’s expected earnings. Paradoxically, while investors have been willing to pay a great deal more for expected profits, those profits have been falling. Corporate profits in the U.S. were up by US$39.2 billion for 90 days ended September 30, 2013 compared with $US66.8 billion in the second quarter ended June 30. Worse, third quarter, 2013 profits from sales in the U.S., which means American consumer-driven sales for the most part, were just a third of what they were in the second quarter.
It is part of everyone’s instinctive sense to avoid paying too much for anything. Those who buy into the stock market now, whether the U.S. market or the Canadian market, which is a tail usually wagged by the American dog, need to know that when the S&P 500 Composite goes over 25, losses follow.
Canada’s situation is different and, unfortunately, worse than that in the U.S. The American economic recovery from early 2009 to late 2013 was driven by households. Americans paid off their mortgage and credit card debts, liquidated overpriced housing through foreclosure, cleaned out credit pyramids and thereby dropped household debt as a fraction of gross domestic product from 95 per cent to about 78 per cent. Meanwhile, Canadian household debt as a fraction of GDP rose from 82 per cent or so in 2009 to about 98 per cent in late 2013. The implication: Canadian GDP growth is likely to be lower than that in the U.S. in 2014 and 2015. Canadian household spending is likely to be flat. Our consumers are tapped out. Canadian corporate profits will lag those in the U.S. and those in the U.S. may not be anything to celebrate.
What to do? Canadian investors are between a rock and a hard place. Fixed income returns continue to be repressed by the Bank of Canada, which is even less likely than the U.S. Federal Reserve Board to permit interest rates to rise in 2014.
Yet bonds, which make promises of paying definite amounts of interest and returning their capital at specific dates, are something you can bet on. Government of Canada bonds with terms of five years pay just 1.74 per cent per year to maturity, but you can roll them as they mature and ride up rising interest rates to what will eventually be about 2.5 per cent for five years and 3.5 per cent for 10 years. You can also buy investment grade corporate bonds and pick up a couple of per cent yield to maturity with very little default risk.
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Currently, the 10-year Government of Canada bond yields 2.55 per cent per year to maturity. A Bell Canada 15-year bond due in 2029 offers 4.77 per cent per year to maturity. That’s a locked in return if you buy the bond and it is not far from a five per cent return on BCE Inc. dividends, though bond interest has no dividend tax credit for a sweetener nor any prospect of rising BCE Inc. stock dividends are likely to rise in future.
The argument for buying high quality bonds rests on the low Canadian inflation rate. If inflation in Canada holds at one per cent and you can obtain a 1.55 per cent return over inflation on the federal 10-year bond or 3.77 per cent over inflation on the BCE bond, you will not lose. Moreover, the present real yield on senior fixed income securities is in the general range of what 10-year federal bonds have generated since the end of the Second World War. If prices stagnate or even drop slightly, it would boost the real return of government bonds and high grade corporate bonds.
This argument does not hold for high yield debt, often called junk bonds. Bonds rated below investment grade tend to be stock in different clothes. These lower quality bonds are priced on their companies’ income statements. When the companies earn more, their junk rises in price. When times are tough and profits decline, their junk bonds follow suit. In a climate of slowly rising corporate profits with the risk of deflation, high yield bonds carry relatively high risk.
Putting a lot of money into actual bonds is a surrender to low prospects for stocks. If you do decide to put money into bonds, you must get the real thing. Reversion to cash, which is the life preserver if interest rates shoot up, only works with an actual bond. Bond funds can carry accrued gains or losses forever.
Bond gains will look even better if mild deflation breaks out. The present inflation rate, barely one per cent, could erode and fall if consumers run down their purchasing power. The deleveraging process going on worldwide is cutting inflation rates. When prices are falling, bond returns gain purchasing power. As long as stock markets are overpriced, conservative investments in actual bonds make sense. †
Andrew Allentuck’s latest book, “When Can I Retire? Planning Your Financial Life After Work,” was published in 2011 by Penguin Canada.