Which is Correct: Stocks or Bonds?

 

Today both stock and bond prices are very high, which is a contradiction that is not supposed to happen. Normally if stocks are rising then bond prices should not be so high. The current post-2008 economic paradigm is different from anything before. Normally in investing we are not supposed to say “This time it is different”. But it really is. The crash of 2008 was the first serious recession to occur since the massive global indebtedness of the past 20 years. It was the first serious crash to occur during a prolonged era of high PE ratios. It is the first big crash since the disinflationary opening up of cheap globalized labor markets in the past 25 years including the deflationary destruction of domestic unionized wage and employment regimes left over from the 1930’s.

Thus traditional metrics may not be applicable. The closest analogies to the crash would be the 19th century era of wildcat capitalism with deep crashes lasting 17 years and no welfare state. But those eras had no massive debt overhang and no Quantitative Easing and no zero percent Fed Funds policy. Perhaps the most appropriate analogy is post-1990 Japan where they have been trapped in a series of deflationary recessions for 24 years. Americans like to reassure themselves that such a thing can’t happen here because we are more entrepreneurial, less bureaucratic, have more immigration and more births. But those things, while important, are not as important as the simple lessons of Japan’s being trapped in excessive debt and finding that its domestic labor costs meant that work would be sent to cheaper EM countries.

When an explorer wanders into a new unknown territory the factor of unknown unknowns increase risk so that prudence suggests being more cautious than usual.  The current era of near deflation (globalization, destruction of jobs, wage cutting, Internet, robotics, etc.) has the potential to continue to maintain a weak labor market and thus weak demand.

No one knows if QE will really work or knows how to fix Japan’s problems. In fixing excessive debt, if one small country has too much debt they usually make arrangements to default and pay off a fraction of the debt with no further litigation. They will also devalue the currency. This works if only a few countries are doing it. I don’t see how it can work if all countries do it at the same time.

It is easy to get fooled by the fact that a debt crisis can appear to be solved by rewriting debt contracts from a 15 year amortization at 6% to a 30 year loan at 3%. But that is misleading because as times goes by the borrower may have legitimate reasons to borrow more, but if he is still not making progress paying down significant amounts of principal on a restructured loan then he may not be able to borrow more years later and this retards consumption, demand, growth, business start-us, and consumer confidence.

Excessive debt is a form of slavery and the world has too much debt, so demand will be suppressed resulting in low growth and low inflation. If a government wants to reduce inflation the textbook answer is to raise taxes so that consumers have less purchasing power. Or if OPEC raises prices that can also take away purchasing power, resulting in a recession. If someone has more debt than they can handle they may gradually realize they need to cut back on debt by selling their home and renting a much smaller residence. That is disinflationary. At some point a drop in demand for new homes would push down commodity prices, upsetting the applecart of commodity speculators who hope to “diversify” buy owning commodities.

Since the 2008 crash the Eurozone has done nothing except a little bit of debt forgiveness for Greece plus their Central Bank has (indirectly speaking) bought government bonds until the price of Spanish government bonds went up and the yield became lower than U.S. Treasuries. Very little serious reform has occurred in Japan since their crisis started in 1990. Massive debts have been accumulated in China with the GNP output from them going down in a form of a diminishing rate of return for each additional amount of debt.

Thus when someone asks a question about the quality of the recovery or the quality of the U.S. labor market I feel that the burden of proof needs to be placed on the bulls. For example, bulls say unemployment is fine in the U.S.; bears say there is a lot of hidden joblessness. Due to the reasons mentioned in this article I feel the more pessimistic explanation of hidden unemployed is correct until proven otherwise.

The bulls’ case for unemployment is that lots of people enjoy dropping out of the labor force to become stay-at-home dads, etc. But why the huge increase in the labor force dropouts when the crash came? Such behavior of enjoying the luxury of quitting work should correlate with times of prosperity, not with a crash. The highest levels of unemployment are among middle-skilled people who were unlikely to suddenly become an affluent enlightened upper-middle class person during a crash and decide to become a stay at home dad or an aspiring musician, etc. Instead these economically weak moderate income people are still struggling because the old economic models that existed more than 20 years ago are broken.

The implication for investors is that GNP growth rates and interest rates will remain low and so will inflation. Bonds are a true economic benchmark and when stock and bond prices provide contradictory answers then stocks are wrong because equities attract emotional, bubble speculative behavior that is rarely seen in bond investors. Investors need independent financial advice about the risks of a stock market bubble and the problems trying to understand today’s strange new economy.

I wrote an article “Is the labor recovery for real or will a crash occur?” 

Special Report:3 Investing MistakesYou Must Avoid!Download Now>>>

About the author

Don Martin, CFP®

Leave a Reply

Your email address will not be published.

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

Copyright 2014 FiGuide.com   About Us   Contact Us   Our Advisors       Login