Investors are scared. Workers are worried. And pessimism reigns. Yet in one market, a boom is under way.bond boom: For the year, the is up about 14% and the up about 12%. Compare that with a measly gain of about 2.4% for the S&P 500 Index ($INX) over the same period.
It's no wonder that investors have yanked $58 billion out of U.S. stock funds this year while pouring $172 billion into bond funds, according to EPFR Global data.
But this very phenomenon suggests we're on the cusp of a huge bull market for stocks. Here's why:
Money in the makingAll of this bond buying is pushing yields lower and lower, making credit cheaper and cheaper for borrowers. Already, more high-yield debt has been sold this year than was issued in the whole of 2009. Even Dubai, the Persian Gulf emirate that rocked global financial markets last November and brought the problem of over-indebted nations to the world's attention, plans to sell $1 billion in new bonds.
, which publishes MSN Money, sold $1 billion worth of three-year bonds last week at a record-low interest rate of just 0.875% -- just a quarter-point more than the yield on comparable U.S. Treasurys. Never before has a business borrowed so cheaply, according to Thomson Reuters data going back to 1970. This follows recent low-cost-debt issues by the likes of , and .
The good news is that periods of stocks underperforming bonds are historically very rare and don't tend to last long. After all, stocks offer something bonds can't: the opportunity to profit from earnings growth. Plus stock returns offer a measure of inflation protection, which bonds lack.
With investors devouring new credit issues and lowering corporate borrowing costs, companies have lots of free money to spend. And that sets the stage for an epic bull market in stocks -- on a scale that hasn't been seen in generations -- as CEOs use cheap credit to enrich themselves and their shareholders.
How epic? Well, a couple of analysts offered realistic numbers this week that would push the S&P 500 past 2,000, with gains of as much as 85%, based on 2011 earnings. (And then there was the analyst who made headlines this week predicting Dow 38,000, bringing back memories of the famous Dow 36,000 prediction a decade ago. I'll call this less realistic.)
Over the long term, we can expect big gains. As I wrote in "Why investors shouldn't be so glum," we're at a rare low point for interest rates and near a Depression-era low in the 10-year return of the S&P 500. Both suggest a multiyear advance lies ahead.
Bond bull on the attackInterest rates are tricky. Fundamentally, they reflect the relationship between the supply and demand for money. But they are also so much more. They reflect inflation expectations. They reflect the level of risk. And they reflect the underlying growth rate of the economy.
So for many, the current bout of ultralow interest rates looks and feels a lot like the situation Japan has faced since the late 1980s (the subject of my column "Is America the next Japan?"). In other words, near-zero interest rates represent a deflationary/low-growth future. In that environment, stock returns should suffer.
But there is plenty of evidence that both the economy and inflation will exceed expectations in the months and years to come -- topics I've discussed in recent columns (see an index of my columns here). And that means stocks are poised to move higher.
What's critical here, as emphasized by Credit Suisse strategist Andrew Garthwaite in a recent note to clients, is that there has been a big fall in bond yields relative to economic growth or prospects for profitability. If investors were truly concerned about the future, then they wouldn't be snapping up risky, high-yield bonds.
Take Freescale Semiconductor as an example. The troubled private tech company tapped the credit market for $500 million in new bonds last week, but demand was so overwhelming that the issue was expanded to $750 million. Just more than a year and a half ago, some of the company's bonds were trading at less than 17 cents on the dollar as bankruptcy loomed. Now, despite the risks still present -- the proceeds will be used to repay old debts -- the market just can't get enough, thanks to the juicy 10.8% yield on offer.
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Businesses are feeling flushBecause of the recent obsession with bonds and the impressive return to profitability by businesses, we're in the midst of a rare situation. Corporate free-cash-flow yields are at 50-year highs versus corporate bond yields. And according to Institutional Brokers' Estimate Systemforecasts, free-cash-flow yields (which are the most conservative measure of a company's earning power) are soon expected to move over bond yields.
What this means is that CEOs can easily add to earnings by borrowing cheaply and investing in stocks, whether their own via buybacks or others via mergers and acquisitions. It's basically a recipe to easily print money -- the same recipe that typically is the exclusive domain of banks, which borrow short-term funds cheaply and use them to buy long-term assets carrying higher yields.
As you can see in the chart below, corporations have plenty of room on their balance sheets to take on some cheap financing. Leverage, represented by debt outstanding versus profits, has returned to the levels that prevailed in the mid-1990s and mid-2000s, periods that preceded stock market gains on the back of mergers, acquisitions and share buybacks.
Credit Suisse's Garthwaite finds that M&A activity tends to lag the business cycle by about a year. Given that the recession officially ended in June 2009, the recent flurry of activity should come as no surprise. Just this week we hadagreeing to buy a smaller rival for $1.4 billion and moving to snap up personal-products company for $3.7 billion.
As deal speculation gets priced into the market and businesses reduce the number of shares outstanding, stocks will move higher. Much higher.
It's happened beforeThe mission of corporate CEOs is to boost shareholder value. If they don't, they get fired. Or their companies get raided by buyout specialists or absorbed in M&A transactions.
Thus there is a constant focus on earnings growth -- which is a function of profits as well as how many times these profits are divided. This, of course, leads to the constant obsession with earnings per share.
Over the past two years, things have gone well for CEOs, thanks to the slack in the labor market, government stimuli and strong demand overseas. Low labor costs and record increases in productivity over the past two years (even with a drop in the second quarter) have helped push corporate profits past the previous peak in 2007.
And now the raging bond bull market gives them the opportunity to borrow money to increase dividends, repurchase shares and snap up rival companies.
Even if, as the pessimists believe, earnings growth is set to slow, CEOs can still use credit to reduce the number of shares outstanding, increasing earnings per share and, thus, stock prices.
Indeed, a historical analysis by Citigroup strategist Tobias Levkovich shows that cheaper credit does, in fact, boost equity valuations. His data show that the price-to-earnings multiple on the S&P 500 Index has a strong inverse relationship to the yield on 10-year Treasury notes plus the equity risk premium. The latter reflects how much "extra" return investors demand to hold equities.
Intuitively, this makes sense: Stock prices are a function of earnings power, borrowing costs and risk appetites.
It gets better: Strategists like Levkovich, who use economic data and historical relationships to make "top-down" estimates, are less optimistic than "bottom-up" stock analysts who examine individual companies. The bottom-up consensus 2011 S&P 500 earnings per share estimate stands at $96. Putting a 22-times multiple on that estimate would push the S&P 500 all the way to 2,112, for a gain of 85%.
If these earnings estimates seem ridiculous, it's worth noting that the "optimistic" bottom-up analysts have been busy raising their forecasts over the past year as companies consistently report better-than-expected results, thanks to cost cutting. The next boost should come from operating leverage as businesses put idled machinery back to work.
And if you think Levkovich is full of it, check this out: His calculations find that the combination of interest rates and equity risk premium explains 67% of the variation in the S&P 500's P/E multiple. As statistical relationships go, that's pretty solid.
Find an edgeSo, how should investors position themselves?
Garthwaite recommends focusing on stocks that are poised to benefit the most from re-leveraging via buybacks. He screened the universe of stocks looking for issues with low debt loads and high free cash flow -- companies that will be most able to increase their repurchase allocations.
In the list generated, large-cap technology stocks dominate. Think, , , and Microsoft. There are also a number of semiconductor companies, including , and .
Also, there is evidence that growth stocks tend to perform best as bond yields fall. This is because lower interest rates make long-term earnings more valuable. Growth stocks trading at a discount include railroad operatorsand , as well as engine producer .
If you don't want to pick and choose individual stocks, that's fine. Just be sure to increase your equity exposure. Otherwise, you risk missing out on what is shaping up to be the greatest stock-buying opportunity of a generation -- just as negative long-term stock returns heading into the late 1930s and 1970s set the stage for fantastic bull markets in the years that followed.
At the time of publication, Anthony Mirhaydari did not own shares of any company or fund mentioned in this column.