Saturday, June 16, 2007

Going hand-in-hand into an uncertain future

Going hand-in-hand into an uncertain future
By John Authers
Copyright The Financial Times Limited 2007
Published: June 16 2007 03:00 | Last updated: June 16 2007 03:00

Bond prices have just gone down, a lot. A 20-year bull market for bonds may have come to an end. How exactly should we expect stocks to respond?

There are many good reasons why there should be some relationship between stocks and bonds.

Stock valuations are supposed to represent the discounted value of a company's expected future cash flows. The rate at which those flows are discounted must depend, at least in part, on the bond market. That is where risk- free interest rates are set.

So falling bond prices should lower the value of stocks. The coupon that bonds pay out remains constant, so a lower bond price increases the yield, or effective interest rate, that an investor will get by buying that bond.

That increases the rate at which stocks' future cash flows should be discounted, and hence reduce the value of stocks.

By raising the cost of finance, higher bond yields also raise companies' interest costs. That reduces the profits that they share with their shareholders.

Higher bond yields also depress general economic activity (and with it, profits and share prices).

There is a further way in which the two markets might be interrelated. This is through a substitution effect. Asset allocation tends to be a game of shifting between bonds and equities.

If an investor has to choose between bonds and stocks, the natural thing is to buy whichever asset class is cheaper. Bonds do not have the chance to log real capital growth in the long run. But if they offer a higher yield, they grow more attractive compared with equities. That would prompt investors to sell stocks and buy bonds, until the gap in value had been closed. Logic points to a fall in bond prices ultimately leading to a fall for stocks.

Then again, bond prices go down if inflation is rising. So do share prices. As bonds are more sensitive to inflation, they can act as a warning signal for stocks.

So the relationship between stocks and bonds looks clear. When bond prices come down, expect equity prices to follow.

The "Fed Model" (so called because comments by Alan Greenspan while running the Federal Reserve suggested he was using it) is the most popular model for finding a "fair value" for the stock market. It holds, with variations, that the earnings yield on stocks (earnings over price, or the inverse of the p/e multiple) should follow the bond yield. P/e multiples and bond yields should have an inverse relationship.

Now we encounter a key problem: experience.

The "Fed Model" worked beautifully for a 20-year period from 1977 to 1997. But bond yields and earnings multiples moved together (the opposite of what is predicted by the model) over the previous 20 years. The relationship also broke down at the turn of the 1990s, as bond and equity yields first rose and then fell together.

Over the last 50 years, therefore, it is questionable whether there is any observable relationship between bonds and equities.

Andrew Smithers once attacked brokers who use the Fed Model for "data- mining". As he put it in the FT, statistics "will always confess if tortured sufficiently". Using all the available data, he said, "there is no relationship at all between bond yields and earnings yields".

How to reconcile logic with experience? Jim Paulsen, strategist at Wells Capital, suggests the inflationary environment is a key variable. When investors are not worried about inflation, as now and in the post-war period, the Fed model will not work.

With inflation out of the picture, then when growth is good, bonds, whose income payments do not increase in line with the economy, are less attractive relative to stocks.

There are still no great worries about inflation. So when growth prospects improve, as they have in recent weeks, then Paulsen reasons, "bond yields go up, and stocks go up".

A different take comes from Vinny Catalano, who runs Blue Marble Research in New York. He suggests the Fed Model is still a good one. Its breakdown once the tech bubble blew up was merely an indicator that the market had been uprooted from the fundamentals.

He models fair value for stocks by projecting earnings and capitalising them using the 10-year bond yield. With just a few adjustments, this works well, he says.

The adjustment has been to increase the bond yield by about 0.9 percentage points - he finds that the stock market is discounting more aggressively than the bond market implies is necessary. Catalano suggests this is because the stock market has been more nervous about the outlook than the bond market.

This leads to a bearish conclusion. The rise in bond yields has left stocks looking overvalued - unless earnings rise by 16 per cent in the next year, which almost nobody expects.

So what does the fall in bonds mean for stocks? Here is a suggestion. The rise in stocks of late has been fuelled by cheap financing. Higher long-term rates endanger this.

Higher bond yields cannot be good news for stocks. But we still do not know if they have risen enough to end the flow of cheap money.

They are a necessary, but not a sufficient, condition for a fall in share prices.


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