James Hamilton looks at recent stock market behavior.
Fernando Duarte and Carlo Rosa of the Federal Reserve Bank of New York surveyed 29 different forecasters and models for their calculation of the expected return on stocks relative to that on bonds. Obviously you want to take anybody’s claim that they know where the stock market is headed with a rather large grain of salt. But it’s interesting that the consensus assessment of this group is that stocks will outperform bonds by as high or higher margin as ever would have been expected over the last half century.
Investment-grade corporate bonds yield about 3 to 3-1/4 percent these days in nominal terms. In real terms, that is something closer to 1-1/2 percent or less. Meanwhile, according to Hamilton, Shiller’s backward-looking P/E ratio on stocks is 23.4. Taking 1 over that, you get something like 4 percent as the real yield on stocks.
It would seem as though any corporation (such as Apple, which has been doing this) that can issue bonds at a real yield of 1-1/2 percent and buy back stock. Rinse and repeat until your bond investors get scared and drive up the yield. This lowers your cost of capital–it is nearly an arbitrage. So much for Modigliani-Miller.
There is something going on in financial markets that I do not understand. Is the Fed’s quantitative easing powerful enough to drive the real ten-year rate below zero? Could be, but I doubt it.
Pundits talk about a huge demand for safe assets. But for me, that does not explain ten-year bond yields. Ten-year bonds do not look like safe assets to me. They look dangerous as hell.
If I ran a hedge fund, my main bet would be deep out-of-the-money puts on bonds. I would keep enough cash to keep rolling over this bet for five years or until it pays off, whichever comes first.
I’m looking at this through my own perspective, considering my reluctance to invest in stocks again.
If we assume people want to avoid any losses at all, more than they want to make outsized returns, maybe they choose government bonds over equity because they just don’t trust equity. I used to think buying equity was better over the long run, but now I’ve seen too many companies manipulate things to benefit managers and stick it to investors. The idea of fiduciary duty to shareholders is a joke now.
I suppose the US Government could do the same thing (rip us all off), but somehow the risk of that feels much lower. If I need to park a billion dollars somewhere, temporarily, I’m not parking it in equity if I don’t trust managers not to suddenly zero out my investment with some undisclosed shenanigans. I’ll park it in 10-years and hope to get out before the music stops.
I dunno… I know this isn’t rational but I just don’t trust anyone anymore. I guess that’s why my retirement funds are in a money-market holding pattern going nowhere.
Suggestion:
Set aside considerations of P/E ratios (for “investment”).
Look at return on capital; and the ratio of productive assets to aggregate capital.
After giving due consideration to the possible priorities of debt obligations, what is the price a purchaser of “equity” is paying for a “share” of the productive assets – and thus for what is produced from those assets (adjusted by any “need” for distributions).
This is sometimes called “intrinsic value.”
I’m not sure I understand why you think of this as “arbitrage.” In the next paragraph, you suggested you don’t think long term rates are as low as they are just because of the Fed’s actions. So how does a corporation shifting from equity to debt to reduce capital costs qualify as arbitrage?
Oh, nevermind. I was thinking you meant it in terms of regulatory arbitrage, rather than old school financial arbitrage.
I think that people think about a US default very differently than a ______ default because in the conventional worldview (right or wrong) a US default of any significance would be an extinction-level event for the global financial system. Heck, in 2008 we were warned of cataclysmic damage if we let AIG or another investment bank go after Lehman collapsed, and those were mere firms, not Uncle Sam.
If you think about things this way (even subconsciously) then it’s like planning for a major asteroid strike: even the best plan has a low chance of success, and the living might envy the dead, especially if the first action of the post-collapse regime is to backstop the politically-powerful losers with funds seized from the “lucky” “profiteers.”
The low yields on bonds and most stocks have me looking at safe utility stocks some of which are yielding over 4%. I guess that a big breakthrough in solar power could hurt them that but I think that they are almost as safe as AAA bonds
I’ve done the same thing the last couple of years: look for companies in unsexy industries with a dividend yield of 3.5% or better, plunk a few dollars on them that I might have previously sunk into some bond index fund or something, then don’t think about it again.