Wednesday, January 7, 2009

What a Bond Market Crash Means for Stocks

All blog entries at Rotten Investments are subject to our DISCLAIMER.

Despite the time and space devoted to the bond market since initiating this blog, I am predominantly focused on stock investing. That bonds had gone bonkers as I was starting this blog was just odd timing on our part. If you're out hunting rabbit and a big, fat squirrel crosses your path, you have to shoot it. They's tasty animals, too. And so it was with our call on the bond market last month.

In the long run, bonds and stocks are only slightly correlated. However, there is an excellent tool for evaluating the investment merits of stocks relative to bonds: the Fed Model.

The Fed Model is not without its detractors and I don't intend to go into great detail in this blog entry about the rationale for, or the efficacy of, using the Fed Model as an asset allocation tool. What is beyond dispute is that over time, stocks have tended to trade at the levels suggested by the Fed Model.

By the Fed Model, it is expected that stocks will tend to trade at a level found by dividing 12 months of forward corporate earnings by the yield of the 10 Year Treasury Note. Arguments about which earnings data to use, whether or not there should be a risk premium added to the equation, or the problem of forecasting future earnings aside, a rise in long-term interest rates tends to make stocks less appealing to investors. And so we would expect a bond market crash to create a drag on future stock returns.

Once again, 1994 serves as an excellent example to review events external to the bond market as the bonds were crashing. At the end of 1993, 10 year Note yields were 5.78%. 1994's S&P operating earnings were 31.75. The Fed Model would suggest that the S&P should trade at 549.30. (On 12/31/1993, the S&P closed at 466.45.) One year later, the 10 year Note was yielding 7.83%. 1995's S&P operating earnings were 37.70. (Fed Model ---> 481.48) The S&P 500 closed the year 1994 at 459.27. So despite a more favorable earnings outlook, against the backdrop of rising long-term interest rates, stocks through 1994 performed poorly.

There are other reasons declining bond prices tend to hurt stocks. Some investors allocate, and reallocate, capital between stocks and bonds in fixed ratios regardless of fundamental valuations. Investors who use an 80/20 asset allocation ratio that rebalance their portfolios quarterly will be taking money out of stocks as bonds decline. Bonds will always compete with stocks for investor dollars, so in the midst of a bond market decline, more attractive bond prices will draw capital away from stocks.

Conditions for stocks should improve through 2009, especially the prospects for forward earnings growth. But the turmoil in bonds this year will probably hamper stock returns. Looking back at 1994 again, the good news is that two to five year stock market performance should be much improved. By the end of 1996, the S&P had risen to 740 and would break 1000 by the first quarter of 1998. We could be setting up for a similar resumption of stock market gains out to the year 2014 or so.

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