Blog: Cutting Through the Noise
Clear and Present DangerPrint
Posted on June 19, 2012
By Scott Ronalds
There are many headline-grabbing risks in today’s investment climate: Greece and the teetering European financial system; slowing growth in China; debt issues and the pending fiscal cliff in the U.S.
Investors can’t be blamed for feeling concerned, frustrated and frozen. Stock market declines and significant redemptions from equity funds (Canadians have pulled over $5 billion out of equity funds so far this year) suggest that many investors are throwing in the towel on stocks. The bond market has been the beneficiary. Demand for Canadian and U.S. government securities is so high that yields have been driven down to all-time lows (when demand and prices rise, yields fall). Yet, even though there is little potential return left in government bonds, these securities are in and stocks are out as the risk switch has seemingly flipped to “off” once again.
Consider the following facts, courtesy of our fixed income manager, Connor, Clark & Lunn:
10-year U.S. Treasuries recently fell below 1.5% (and 10-year Government of Canada bond yields below 1.7%). The current rate of inflation is over 2.5%. Investors are willing to lend their money to the government for a decade in return for negative real returns (after-inflation).
- The earnings yield (earnings per share divided by market price) on the Canadian and U.S. stock markets are at all-time highs compared to government bond yields.
- Dividend yields on stocks are higher than fixed income yields at a time when corporations are in excellent financial shape and payout ratios are on the low side.
Playing it safe over the past several years by investing in U.S. or Canadian government bonds is a strategy that has produced excellent returns. Taking prudent risk by buying shares in well run blue-chip companies has produced meager, if any return.
In CC&L’s words, “Somehow this seems upside down to us, but that is the world we have been living in and one that the majority of investors have come to believe is the new norm. Our suspicion is that at some point the emperor will be seen to have no clothes and the bubble that has been developing in the bond market will succumb to the same fate as those that preceded it.”
Looking forward, CC&L suggests investors should be asking the question of which investment looks more risky: (1) a security where the underlying issuer is running a large operating deficit, piling up new debt, and offering a negative real return over the duration of the investment – i.e., U.S. Treasury bonds; or (2) a security where the underlying issuer is generating positive and improving cash flows, paying a growing dividend, and has a strong balance sheet – i.e., blue-chip corporations.
The risks for investors today are clear and present. Or are they?