The high cost of buying stocks and bonds in a boom market

With financial prices rising, prudent investors need to be cautious in the marketplace

It is a paradox of off-farm investing that, as the U.S. economy strengthens and the Canadian economy gains speed, albeit sluggishly, buying stocks and bonds is getting to be harder, not easier.

The reasons are, of course, that many other investors have already made their bets, bought the stocks they expect to rise, put money on bonds they expect to be rewarding, taken option positions and set cash reserves for what may be new entry points. That explanation would seem to say that the game is over. But that would be false.

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There are new realities in financial markets and they are what every investor on the farm or off has to keep in mind.

Market realities

Stocks are increasingly priced for good news. The major stock indices are now over their bull market average levels. Thus the American S&P 500 Composite index, which began to hit all time records at the end of August, is priced at 19 times the average annual earnings of its constituent companies. That is a little over the 16 multiple historical average, but that alone does not predict a fall. After all, as the economist David Rosenberg, a sage of both Wall and Bay streets and chief market guru of Gluskin+Sheff, an eminent Bay Street wealth manager, has said, it is not an average that brings markets down. It takes an event to do that. So far, the events — chaos in the Middle East, for example — have not budged the market very much.

We’ll come to what could break the up cycle of stock market prices a little later, but first we have to mention what the bond market is doing. It, too, is providing terrific returns even in the face of the expectation that someday soon, interest rates will rise. The Fed and the Bank of Canada are easing off bond buying, thus allowing bond prices to fall and bond yields, which move opposite to interest rates, to rise. Ordinarily, the prospect for falling prices would flush money out of the bond market. But these days, it is the opposite. The reason: bonds are not being priced on the usual variables of expected inflation or demand for money. Rather, bonds are being bought as commodities on a simple supply and demand basis.

Stocks and bonds are the two major asset classes. Investing doctrine says that when one asset class rises, one should take some money off the table and rebalance. Thus with major stock averages such as the TSX and the Dow Jones Industrial Average about double their value at the lows of March, 2009, many investors are taking some profits and buying bonds. That pushes up bond prices and pushes down bond yields, which move opposite to prices. What is most remarkable is that investors have put a great deal of money into long-dated government bonds. Canadian bonds with terms 10 years and over are up 8.7 per cent in the first six months of 2014, which is a remarkable gain in an ongoing recovery in which they should be losing value.

Could it be that bond investors are acting prudently in view of the future and not just buying bonds with their stock market gains? Read the newspapers and you’ll see abundant geopolitical risks, any number of which could plunge the world. The Middle East offers crises in Gaza, Syria, Iraq, Afghanistan and the moving target of the bloodthirsty Islamic State. Africa has the Ebola crisis. Moreover, the market is ready for a correction, for it has risen with few backsteps since the recovery which began in March, 2009. That is a five-year run. Stock market convulsions happen every three to six years. There were crises in 1987 when the New York Stock Exchange dropped about 23 per cent; 1998 when bond manager Long-Term Capital Management went bust and the Thai currency collapsed; 2000 when the dot com boom imploded; 2001 when tragedy struck New York; and 2008 when an overvalued market collapsed after investment bank Lehman Brothers imploded. That series of disasters did not end the crisis. Just wait — there are more to come.

What to do

What’s an investor to do? The endless cycles of greed and fear are in the greed phase now. The prospect that Tim Horton’s will take over Burger King in a spectacular restructuring driven by tax savings, financed by Warren Buffet and managed by the Brazilian company which owns Burger King has rocketed up Tim’s share price and created a feel good atmosphere on Bay Street.

But can it last? That depends on timing, patience, and your view of the market. As I write this column, Tim’s is priced at more than 29 times last years’ earnings. Revenue growth is a modest 4.3 per cent, though the company’s return on equity is a spectacular 53 per cent. A conservative investor would say that paying 29 times last year’s earnings is rich for a 1.4 per cent dividend and sluggish top line sales growth. But the Tim’s-Burger King merger is about synergies and perhaps tax savings. It’s about future growth, not present payouts.

We need to talk about the fundamental market forces: Stocks with low ratios of share price to earnings below 10 or so are held down by the momentum or prejudice that they are slugs doomed to remain market outcasts. Stocks with p/e’s over 20 or 30 or more are trading on the momentum view that what goes up, goes up. Neither view is right, for regression to the mean, boosting market laggards and hauling down high flyers is a far more powerful force than low prices for the slugs staying low and high prices for winners going even higher.

The time to buy a hot stock is, of course, before it got hot. When it is hot, caution is essential. You can buy that caution in an equally weighted exchange traded fund — BMO has several such as the BMO Equal Weight Industrial Index ETF, symbol ZIN on the TSX, in which each stock is three to four per cent of the index. That gives some advantage to bottom feeders and keeps the winners’ curse of overpricing from tainting the index. Equal weight indices tend to outperform market weight indices most of the time. You may give up some dividend returns characteristic of the biggest companies, but you get more growth in return. Most of all, you tend to get a lower p/e than if you buy the market-weighted winners index. BMO has equal weighted indices for banks, oils, utilities and real estate investment trusts. Other ETF providers such as iShares have a variant on equal weight indices. They use capped indices that hold the weight of winners down to a specific level, thus avoiding the Nortel effect which, at one time had the now bankrupt telecom manufacturer responsible for a third of the total value of the TSX.

A prudent investor is seldom an enthusiast. Courageous perhaps, but not a fool rushing to throw money at a train that is already past. Sadness, it is said, is the mother of memory. Overpaying for overpriced stocks is a memory, and a sadness, you don’t need.

Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life After Work, was published in 2011 by Penguin Canada. †

About the author

Columnist

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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