In response to the question “Are Stocks a Screaming Buy Relative to Bonds?” I received many comments that I would like to share.
On False Premises
My friend Rich replies ….
You said: “The first mistake is assuming choices are limited between stocks and bonds. The question “Will it be stocks or bonds?” creates an unnecessary false premise. One does not have to be in either.”
Well, that is not true – at least on Wall Street! The question “will it be stocks or bonds?” is driven by money managers and fund managers and stock brokers, all who are committed to you being fully invested so they can earn their fees.
Indeed. I have commented on this before. Wall Street does not generally get paid on funds sitting in cash. The second money comes in it is “put to work” earning fees, regardless of the risk-reward setup for the client.
Conflicts of Interest in “Stay the Course” Advice
Here is a snip from Long Term Buy And Hold Is Still Bad Advice
Clearly, stay the course is bad advice. So why is it so common? A personal anecdote might help explain things: In January of this year, an investment advisor from Wachovia Securities called me up and stated “Mish, I am sitting on millions because I see nothing I like”. I told the person I did not like much either and that Sitka Pacific was heavily in cash and or hedged. His response was “Well, I do not get paid anything if my clients are sitting in cash”.
I called up a rep at Merrill Lynch and he said the same thing, that reps for Merrill Lynch do not get paid if their clients are sitting in cash.
Massive Conflict of Interest
Notice the massive conflict of interest possibilities. Reps for various broker dealers have a vested interest in keeping clients 100% invested 100% of the time, even if they know it is wrong. And so it is every recession, bad advice permeates the airwaves and internet “Stay The Course”.
By the way, that person at Wachovia mentioned above did the right thing. He did not see investment opportunities he liked, so he kept client funds in cash. Such action is certainly is not the norm.
Discrediting the Fed Model
“VegasBob” writes …
One point Mish alluded to but didn’t explicitly state is that John Hussman has thoroughly discredited the ‘Fed Model’ that is used as a stock valuation metric.
There is no evidence of any cause and effect relationship between stock prices and T-Note rates. Ergo, the ‘Fed Model’ is just another crock.
I posted a link to the Hussman reference in my original post.
Here it is again: Long Term Evidence on the Fed Model and Forward Operating P/E Ratios.
In recent years, price/earnings ratios based on “forward operating earnings” have been embraced by Wall Street as a replacement for valuations based on trailing net earnings. The beliefs of investors about what represents a “normal” P/E, however, have not changed – despite the change in the earnings measure being used. Meanwhile, the Fed Model – the notion that the earnings yield of the S&P; 500 (based on forward operating earnings) should be equal to the 10-year Treasury bond yield, has been embraced as a simple and reliable method of valuing stocks.
It’s likely that these beliefs will prove disastrous for investors.
The assumed one-to-one correspondence between forward earnings yields and 10-year Treasury yields is a statistical artifact of the period from 1982 to the late 1990’s, during which U.S. stocks moved from profound undervaluation (high earnings yields) to extreme overvaluation (depressed earnings yields). The Fed Model implicitly assumes that stocks experienced only a small change in “fair valuation” during this period (despite the fact that stocks achieved average annual returns of nearly 20% for 18 years), and attributes the change in earnings yields to a similar decline in 10-year Treasury yields over this period.
Unfortunately, there is nothing even close to a one-to-one relationship between earnings yields and interest rates in long-term historical data. …
Hussman’s August 20, 2007 statement “these beliefs will likely prove disastrous for investors” was right on the mark.
My friend “HB” writes …
The Fed’s ‘stock market valuation model was a brainchild of the dot-com mania. It has been the funeral rite for many an unwisely invested dollar.
Another friend writes …
Yardeni has been saying stocks are cheap relative to bonds for the last 8-9 years, since shortly after the tech bubble burst. By the same token, stocks were cheap in Japan from the mid-1990’s onward. Such analysis clearly shows the limitation of valuation studies without an understanding of market cycles. Like the saying goes, “what is cheap can always become cheaper.”
Deja Vue All Over Again
As Yogi Berra said “This is like deja vu all over again” with the same tired, disproved, “stocks are cheap” arguments. The worst part is investors are bombarded with such nonsense, fresh on the heels of a 80% runup in stock prices, in other words, at precisely the worst time.
Mike “Mish” Shedlock
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