Why stocks are safer than bonds now

The growth problem

Consider the shift away from the U.S. dollar by overseas central banks. For bonds, that's an unmitigated negative. Less demand for the dollar at a time when government and corporations keep pumping out more dollar-denominated bonds means that issuers will have to resort to higher yields to make their bonds attractive to buyers.

But a weaker dollar, while it does raise costs for companies that source raw materials overseas, also results in a huge sales edge for U.S. exporters. Caterpillar (CAT, news, msgs) equipment looks cheaper to buyers in Europe, for example, because appreciating euros buy more dollars. And a weak dollar also pushes up the earnings of companies that do substantial business in nondollar economies but that report their earnings in dollars. McDonald's (MCD, news, msgs) earnings from France and Australia get a currency boost when local currencies are converted to U.S. dollars on the corporate books.

The biggest difference in the way these macro trends affect bonds and stocks comes from higher economic growth. Higher growth, at least in the current economy, only raises fears of inflation and dashes hopes of an interest-rate cut by the Federal Reserve. All that hurts bond prices. Higher growth, on the other hand, is a boon to equities, since more growth often means more profits. Higher growth has an especially positive effect on equities at a time like this, when the consensus worry has been that growth was about to slow so much that company profits would stagnate or decline.

No sweeping threats to equities

Moving from these macro trends to the micro structures of the bond and equity markets, the picture at the micro level is actually even more favorable to stocks over bonds. In my last column, I compared the bond market to an old house where decay to the structure threatens the collapse of the whole building.

The stock market certainly isn't without its own structural defects. Too much cheap money has led companies to add excessive debt to their balance sheets in order to pay out higher dividends and buy back shares. And cheap money has produced an unsustainable boom in residential real estate that is now ending, with considerable pain for homebuilders and mortgage lenders.

But the problems in the equity market are, currently, limited to specific sectors or industries or companies. They represent mines that could blow up under the feet of the unwary or careless.

The micro problems in the equity markets aren't yet sweeping enough to present a threat to the whole structure of the kind that I see in the bond market.

The mortgage crisis

Let me give you an example from the mortgage debacle to show you what I mean. In the equity markets the effects of that debacle have sent shares of home builders plunging: Shares of Lennar (LEN, news, msgs), for example, were down 38% from July 2005, as of June 18. It has punished the shares of companies that supply the industry: Pentair (PNR, news, msgs), with its exposure to the market in residential water pumps, has seen its stock fall 42% from July 2005 before a recent recovery reduced the drop to 19% from the 2005 highs, as of June 18. The debacle has forced some lenders into bankruptcy or near bankruptcy. And some ripples have moved out to hurt companies in the general economy such as Wal-Mart Stores (WMT, news, msgs).

But, so far at least, that's a very measured response. Sure, the Dow has dropped 200 or even 400 points in a day, but the market hasn't had an honest-to-God correction in years -- a 400-point drop is just a 3% decline -- let alone a panic like the 10.5% drop in Treasury bond prices that bond investors have just been through.

Leverage and more leverage

Compare this market structure to what the bond market has built on the same mortgage assets. Risky subprime mortgages have been packaged and sold so that lenders could make more loans and then sell them. Those packages have been used as collateral by hedge funds and other players, so that they can borrow more money in order to buy more packages. Borrowing $10 on every dollar of assets isn't uncommon. Then to "offset" the risk of those leveraged assets, bond market players have created new assets -- derivatives of various flavors -- so that they can buy and sell the risk of those underlying assets. More leverage.

Other bond market investors have sought to balance risk by buying classes of debt instruments that, theoretically, move in different directions when interest rates rise or bond prices fall.

So, for example, in the recent bond market panic, Merrill Lynch (MER, news, msgs), one of the Wall Street institutions that lent a Bear Stearns hedge fund $6 billion, got nervous at the size of the hedge fund's losses and seized the collateral behind its loans. The hedge fund had been engaged in a frenzy of selling of whatever it could sell at whatever price it could get to stave off just that kind of move. By moving to an auction on June 20 of the $850 million in fund assets that had been the collateral for its loans, Merrill Lynch could set off a massive re-pricing of mortgage-based securities and derivatives that extends far beyond Wall Street.

When the rise in interest rates sent the rate of mortgage refinancings plunging, holders of big portfolios of mortgage-backed debt rushed to sell U.S. Treasury bonds. Why sell safe Treasurys when the problem was in the mortgage debt market? The slowdown in refinancings meant that the mortgages in these portfolios were more likely to reach maturity in 30 years. These portfolios now had a longer maturity -- which means more risk (since the longer you hold a bond the more likely it is that something will go wrong). Holders of mortgage-backed portfolios then moved to sell long-term Treasury bonds to reduce the maturity of their portfolios to less risky levels.

Layers of risk in the bond market

It's this combination of high leverage, which increases the risk that a little explosion will turn into a big bomb, and intense interrelation of seemingly unrelated parts of the market that makes the bond market so dangerous right now.

I can't think of a comparable marketwide, risk-magnifying structure in the equity markets.

Even China doesn't come close. True, the health and wealth of big hunks of the equity market hinges on China's ability to keep growing at 10% plus a year without blowing up. And true, the likelihood that China will be able to grow at 10% forever without melting down or freezing up some year is nil. I've written in an earlier column that the maximum danger point comes in the period after the Beijing Olympics in August 2008. (See "China's Olympian stock market sprint".)

Look to growth stocks

But without the kind of 10-to-1 or more leverage practiced routinely in the bond market these days, even China isn't big enough. Derivatives based on bonds and loans totaled $30 trillion in 2006, according to the Bank for International Settlements. China's GDP is a piddling $2.5 trillion at the official exchange rate ($10.1 trillion at purchasing-power parity).

For this year, there's upside in the stock market at tolerable risk. The best bet to make, I'd say, is on higher-than-expected growth. It's a good bet because so many investors have bet the other way for much of the year. I know because I started the year in the lower growth camp and moved even more in that direction after the growth slump in the first quarter. I don't think I am alone. And that means that prices of growth stocks should benefit as investor sentiment rediscovers growth.

Continued: Total overhaul unnecessary

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