Sunday, 12 January 2014

Stock bulls celebrate low bond yields

Stock bulls celebrate low bond yields

Something strange has been going on in the bond market, and, so far at least, it has been great news for stocks.

As the Federal Reserve has continued to raise shortterm interest rates, longerterm governmentbond yields haven followed suit. They have fallen back to levels that some experts didn expect to see again in their lifetimes.

After declining for two months, the yield of the 10year Treasury note was at a paltry 4.08 percent Friday, well below the 4.6 percent level at which it stood when the Fed started raising shortterm rates a year ago. Prime lending rates, pegged to the Fed rates, are up. But fixed mortgage rates and some corporate borrowing rates, which are pegged to bond yields, are at or below yearago levels.

For a few stock investors, this conundrum, as Fed Chairman Alan Greenspan has called it, is bad news because it could presage a weak economy.

But the prevailing view in the stock market is one of celebration. Many stock investors believe falling bond yields are predicting some good news indeed: low inflation, moderate economic growth and an end soon to the Fed rate increases. That kind of Goldilocks economy, not too hot or too cold, would be fine for stocks.

The result: For more than a month now, since it became clear what Treasury yields were doing, stocks have been on a tear and they have been led by some of the more speculative parts of the market.

The Nasdaq Composite Index, which includes many volatile technology stocks, has risen 9 percent since its recent low April 28. The Dow Jones Internetstock index has risen 17 percent since April 15. The Dow Jones Industrial Average, with its more staid bluechip stocks, is up 5 percent since April 20, including a gain of 70.64 points, or 0.7 percent, last week.

If the optimists are right, then the stock gains could continue for months or even years to come, although probably not at this same rapid pace. But some analysts fret that this view is far too rosy and that the bond market may be telling a darker story. Over the past 35 years, the skeptics say, Fed rate increases have tended to end with trouble, most recently the Russian debt default and Asian economic crisis of 1998 and the bursting stock bubble of 2000. That underlying fear helps explain why most stock indexes still aren back to where they began this year. It is why traders and money managers are watching the bond market with a mix of hope and anxiety.

That is the biggest question right now: What does this decline in bond yields really mean? says Warren Epstein, head trader at brokerage firm Kabrik Trading.

For Marc Stern, chief investment officer at New York moneymanagement firm Bessemer Trust, the bond market message is simple. Low yields mean that bond investors expect low inflation and low market interest rates. And that is good for growth and for the stock market.

The most likely case is steady economic growth. It isn going to be boom times, nor is it going to be a recession, Mr. Stern says. A lot of people, he says, including some of his own clients, worry that some kind of negative event is looming. But we feel that the fears that are out there are overdone and that the fundamentals are favorable.

Where would he put money? When an economic expansion is growing older and growth is more moderate, big, steadyperforming stocks are the place to be, Mr. Stern says. He thinks the speculative stocks will lose momentum soon and that stocks such as Microsoft, Baxter International, Avon Products, United Technologies and Motorola will hold up better.

If the bond market doesn collapse, and if inflation doesn get too bad, you should do OK, he says. investment strategist at brokerage firm Merrill Lynch, doesn buy it. When longterm rates fall as shortterm rates rise, he says, the bond market is telling us that the economy is going down a growth path that is weaker than average. He isn forecasting recession, but he thinks slow growth will lead to disappointing corporate profits, hurting many stocks. He thinks Treasury bonds are the place to be, and he forecasts that their prices will keep rising and their yields will keep falling. He also likes defensive stocks such as utilities and healthcare stocks, which offer strong dividends and steady businesses that protect investors even in a soft economy.

He believes the Fed Mr. Greenspan is showing no sign of ending his rateincrease campaign. Since 1970, the Fed has never ended a tightening cycle without a financial calamity causing them to do so, Mr. Bernstein says.

True, stocks did rise sharply in 1995 despite a series of Fed rate increases that caused serious trouble in the bond market. But Mr. Bernstein says today is nothing like 1995. In 1995, he says, Wall Street strategists were skeptical of stocks, and the market rose as investors slowly were converted to bullishness. Today, the strategists already are bullish, and expectations for the stock market already are too high, he says, leaving stocks ripe for a disappointment.

Other influential analysts share his view. William Gross, who manages one of the world largest bond funds at Pacific Investment Management in Newport Beach, Calif., also is warning of a soft economy and has written that the 10year Treasury yield could fall as low as 3 percent, as Treasurynote prices rise still higher.

Can yields stay low? I think they can. I don think they are going to explode higher. I don think our economy can support it, says Jack Ablin, chief investment officer at Harris Private Bank. He, too, likes big, steady stocks with significant dividends, such as healthcare, utility and telecommunications issues. A lot of this year stock return could come from dividends, he says.

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