First of all, credit where due: today’s title came from David Rosenberg of Gluskin Sheff, a terrific economist whom I read daily. I laughed the first time I saw it, but per yesterday’s post, I’ve come to believe that it has real applicability to most client portfolios.
The larger point here, though, is that the new new normal we now live in has forced us to reexamine many assumptions. To the extent that portfolios are based on how things were, and not how things are, we may be in the wrong place. The title above is a great way to express that.
Historically, fixed income has been about just that—income. For the past couple of decades, stocks were about capital appreciation; income didn’t come into play in the popular imagination. The reality was somewhat different, but never mind.
With interest rates so low, fixed income has necessarily become less about the income. According to research by Peter Essele of our Asset Management group, the gap between bond yields and the dividend yields of the equity universe is at historic lows.
With that narrowing gap, the markets are telling us something. Income yield in the fixed income market is a reasonable proxy for risk—the higher, the riskier. For each bond, the question is “Are we getting paid for the risk we’re taking?”
With stocks, the metric is expected total return, but for dividend-paying stocks, income comes into play. Therefore, if the effective yields are similar for bonds and stocks, the market is essentially saying that bonds are now roughly as risky as high-yielding stocks.
Think about that for a minute. In the new new normal, bonds and stocks are considered by the markets to have similar risk levels, at least when measured by coupon and dividend yields. There is quite a bit of variance, of course, and I’m stretching the point a bit. But as a general factor, this is unusual, to say the least.
For recent decades, that is. If you look back, though, at one point, stock yields were expected to be higher than bond yields because they were riskier. Are we moving back to that time?
I would argue that we’re not. The change in behavior hasn’t been driven by the markets, but by Fed intervention. Ben Bernanke and his team have aimed to force investors out of low-risk assets and into riskier assets to meet their goals, and they have succeeded.
What does this mean? First, the current situation is not sustainable, and conditions will change when the unusual stimulus—Fed intervention—goes away. Second, the key factor here is bond rates. When they change, the valuation effects will ripple through all asset classes.
As I said yesterday, I don’t expect bond rates to change in the near future, but when they do, the effects will span all asset classes—something portfolio construction should bear in mind. I’ll discuss that topic in the next couple of posts.