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In my last column I painted a grim picture of the bond market. I argued that bond prices tumbled in late May and early June because outside forces, such as rising interest rates overseas and a falling U.S. dollar, exposed the rot in the bond market. That structural rot ensures that bond investors will face repeats of this bond-market panic periodically through the rest of 2007. With CDs yielding 5.25%, I don't see a reason to own bonds right now.
But what about stocks? Is the picture just as grim for the equity market?
No. The big-picture trends that weigh so heavily on the bond market right now are much less negative for stocks. And the rot in the bond market that's so likely to keep bond trading desks on the edge of panic this year aren't factors in the equity market at all.
We're at one of those unusual times when bonds will suffer but stocks will do relatively well -- at least for the next 12 months. Even after the June bond debacle, stock investors could well see a 12% to 15% return on the major indexes in 2007. That's not a terrific advance from where we are now -- as of June 18 up 9.7% for 2007 on the Dow Jones Industrial Average ($INDU) and 7.9% on the Standard & Poor's 500 Index ($INX) -- but it's sure better than a poke in the eye with a sharp stick.
Trends that burden bonds
Let me tell you why, when I'm so negative on the bond market, I'm relatively optimistic about stocks.My argument breaks down into two main parts. First, the same macro trends that are almost uniformly negative for bonds have some undeniable upside for stocks. And second, the structural problems in today's bond market that will drive down bond prices in the next bond panic are largely irrelevant to stocks.
I gave a very fast rundown of the big-picture trends now working against bonds in my last column, "Steer clear of the rotting bond market." Let me amplify a bit. Here's my original list of trends working against bonds:
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- Interest-rate increases from all of the world's major central banks, except, so far, for the U.S. Federal Reserve.
- Rising food and energy inflation around the world -- almost 7% in the first quarter of 2007 in the United States.
- The end of the "Wal-Mart inflation bonus" as China, India, Vietnam, etc. shift from exporting deflation to exporting inflation.
- A shift away from the dollar by overseas central banks.
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To these, I'll add a fifth point:
A quick resurgence in U.S. growth from the 0.6% slump in the first quarter. After the release of recent job and trade numbers, economists have been busy increasing their estimates for second-quarter growth. JPMorgan Chase (JPM, news, msgs), for instance, upped its forecast for second-quarter GDP growth to 4% from 2.5%. Faster economic growth isn't good for the bond market, of course. Faster growth raises the possibility of higher inflation, and it pretty much puts the kibosh on hopes that the Federal Reserve would cut interest rates this year to get a slow economy moving again.
Some of these trends hurt stocks -- as well as bonds. Rising prices for goods sourced from China and India puts pressure on corporate profit margins, for example. And higher interest rates take a bite out of earnings at any company with debt on its books.
But -- and it's a crucial "but" -- most of the five macro trends that are so negative for bonds offer at least a bit of upside for stocks, and some offer quite a bit more than a bit.
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