Don’t Buy Bonds Yet. Stick With Stocks. The Chart That Shows the Next Recession Is a While Away.

Oct 16, 2018 by Gary Gordon

Don’t Buy Bonds Yet.  Stick With Stocks.  The Chart That Shows the Next Recession Is a While Away.

Last week the 10-year Treasury bond yield hit 3.2%, its highest yield since 2011.  And last week the stock market got beat up pretty good.  So is it time to shift some investment assets from stocks to bonds?  I believe the answer is “No”.  And this comes from somebody who is very often is not wrong.

 

Bonds are still not “absolutely” cheap.

Investment allocation is mostly about relative values – which has the best risk/reward profile, cash, bonds or stocks.  But we can be tempted by returns which just seem good on their own merits.  After a full seven years where the 10-year Treasury bond yield started with a 1 or a 2, seeing a 3 handle is pretty stirring.

Or is it?  Check out this chart, which shows the “real” yield on the 10-year bond.  The real yield is the nominal yield less the inflation rate:

 

 

Sources: Federal Reserve, Department of Labor

 

The current real yield is a paltry 0.7%, because the CPI is running 2.5% above a year ago.  That is way below the average, and not much of a return for the risk of tying up your money for ten years.  And a rise in inflation above the current 2.5% is a real possibility:

“…A record 37% of small businesses in September ‘reported raising overall compensation in hopes of hiring and retaining needed employees…The competition for qualified workers is pushing up compensation.’”  (Wall Street Journal, October 4, 2018)

 

In sum, a 3.2% 10-year Treasury bond yield doesn’t attract me.  4%?  You’ve got my attention.  5%?  I’m in.

 

When bonds outperform stocks.

As I said above, investment asset allocation is mostly a relative game.  So when do bonds outperform stocks?  This chart provides an important clue.  It measures the annualized return, over the following three years, of stocks versus bonds, since the year 2000, with recession noted:

 

Sources: Standard & Poor’s, Yahoo Finance, Federal Reserve, National Bureau of Economic Research

 

The chart says that bonds outperform stocks when investors sense a recession is imminent, and outperform well into the recession.  So is a recession imminent?

 

Certainly, economically sensitive stocks are trading as if that is the case.  General Motors has a 20% earnings yield (5 P/E), Ford a 17% earnings yield, homebuilder Pulte Homes (one of my favorites!) a 17% yield and consumer lender Capital One a 12% yield.  For comparison, the overall market is at a 6% earnings yield.  So investors are clearly forecasting that these companies are about to get a significant earnings hit, presumably due to a recession.

 

So is a recession around the corner?  A chart says it is unlikely.

This chart says no.  It measures real private sector debt growth (consumers and businesses), and again notes recessions:

 

Sources: National Bureau of Economic Research, Federal Reserve

 

For all of the recessions back to 1960, the pattern was the same – a private sector debt bubble, followed by a bust and a recession.  Why?  Because when lenders’ loan losses are low, they lend until they bubble, which then causes them to stop lending, which in turn causes the recession.  This history of bank chargeoff rates reiterates that point (chargeoff data only goes back to 1984):

 

Sources: National Bureau of Economic Research, Federal Reserve

 

The debt growth picture shows no sign of a debt bubble at present, and therefore no sign of a recession.  Neither does the chargeoff picture.  For further proof, here’s evidence from just-released bank Q3 earnings reports:

 

“Overall default rates continued to trend lower. JPMorgan charged off 0.45% of its loan portfolio during the third quarter, down from 0.58% a year go. Wells Fargo’s overall charge-off rate fell to 0.29% of its loan book.”  (Wall Street Journal, October 12, 2018)

 

Banks therefore have no reason to slow their lending.  In fact, history would suggest that a bubble is still ahead of us.

 

No near-term recession leads to me to continue to overweight stocks and underweight bonds.

 

Why is this time different?

How come lenders haven’t yet stupidly bubbled up as they historically have?  Have they learned from history?  Hah.  Dealt with their all-too-human lack of emotional control?  Unlikely. 

The answer is that the regulators made them do it.  In the wake of the ’08 financial implosion, Congress passed the Dodd-Frank Act, whose stringent capital and other rules limited over-lending and other aberrant lender behavior.  Yes, Dodd-Frank, with all of its warts, has made lending far more rational.

I know I have a lot of charts, but I can’t resist adding one more amazing one.  Simplistically, the funding for bank loans comes from their deposits.  They usually keep some excess deposits.  This chart measures the amount of excess deposits since 1975, adjusted for inflation:

 

Source: Federal Reserve

Wow!  Can’t get a more graphic impact of Dodd-Frank.  Its limitations have reduced private sector debt by upwards of $2 trillion.  Thank you, Chris Dodd and Barney Frank.

 

So why are investors pricing in a recession?

For one, investors could be wrong.  It happens all of the time.  As economist Paul Samuelson famously said, “The stock market has forecast nine of the last five recessions.”  They could be wrong this time around because of faulty thinking that we are “due for” a recession after a decade-long expansion.  Or that the Federal Reserve interest rate increases will choke off the economy.  I don’t agree, but there’s a lot of people out there who aren’t me.

 

Could the next recession be imported?  Or political?

Yes, our financial system has been (however reluctantly) responsible over the past decade.  But that is not true elsewhere.  China is in the midst of perhaps mankind’s greatest debt bubble.  Italy, Argentina, Venezuela, Turkey and some other smaller countries have been fiscally naughty.  Bursting of those bubbles will spill over to the US to some respect. 

 

And how about an all-out trade war with China and possibly multiple fronts?  One serious enough to cause an actual recession seems too crazy to imagine anyone waging, but crazy is what we humans sometimes do.  JP Morgan CEO Jamie Dimon recently publicly worried about “…these increasing overseas geopolitical issues bursting all over the place.”

 

Wrapping up…

I continue to recommend overweighting stocks over bonds because:

 

  • Bond yields still stink relative to inflation.
  • I expect the US economic expansion to continue for the foreseeable future.  If so, stocks are highly likely to outperform bonds.