After seven very bumpy months, the stock market has produced double-digit returns for investors who have managed to stomach the ride so far in 2012. A rally over the past two months has boosted stocks near their highs for the year.
Meanwhile, US Treasury bonds are trading at values that suggest a meteor might soon hit earth and plunge us into darkness. The world’s safest haven for fixed-income money offers investors paltry yields on Treasury securities, some of which fell to all-time lows earlier this month. Shorter-term bonds now provide such meager interest rates that investors are essentially paying the government to take their money, once routine expenses are taken into account.
How can investors put their money into markets with such disparate views of the future: the relatively upbeat expectations baked into stock prices vs. the deep pessimism expressed by bond yields.
More important: Which one is right?
“It would seem like something’s out of whack,” notes Jim Swanson, chief investment strategist at MFS Investment Management in Boston. “A very low Treasury yield would normally signal a recession, but the stock market keeps going up.”
This is not a new question and, in fact, stocks and bonds have been moving in these opposite directions for some time. But the difference in outlooks has become even wider recently.
The stock market is climbing, despite evidence of a slowing US economy, persistently high unemployment here, and numerous economic trouble spots abroad. The Standard & Poor’s 500 index is up 10.2 percent so far this year.
The bond market, meanwhile, is trading at extremes beyond those registered during the height of the financial crisis in 2008, despite the fact that banks have since stabilized and the US economy pulled out of recession long ago. High demand for the 10-year Treasury rate, an important benchmark for mortgages and other forms of credit, has driven yields down to an astonishingly low 1.5 percent.
One explanation for the divergence between the financial trends: Stock and bond markets are measuring different things.
Stock prices go up and down based on a company’s ability to make money. Higher profits mean rising stock prices. Companies maintained extraordinary high profits through the recession and recovery, often by cutting costs sharply.
The bond market tends to reflect an outlook on the economy. Low bond yields may suggest recession — or simply a very long period of painfully slow growth that doesn’t merit higher interest rates.
In recent years, any debate about the divergence between stocks and bonds has focused on the influence of the Federal Reserve. The Fed has acted aggressively to spark the economy, first by keeping short-term interest rates near zero and later by buying mortgage securities and other longer-term debt to keep those rates low, too.
Very low interest rates are a plus for borrowers who could use money to expand businesses or buy products. The Fed did not mind that such a strategy might drive more money into the stock market because safer investment alternatives such as bonds had such low returns.
Now Fed chairman Ben Bernanke may take action again, and that expectation is influencing some investors. Speculation about a possible third round of monetary stimulus has convinced many investors that the Fed will remain committed to holding interest rates very low.
But it isn’t obvious what more the Fed can do to make a real impact. Bernanke has already used practically every tool available to him, tapping the Fed’s vast resources.
Some investors, including Swanson at MFS, don’t think that matters much. Markets are convinced the Fed will act and that is enough to influence bond rates and prices.
“Whether they’re going to do [more stimulus] or not doesn’t matter. There’s a distortion in the market. Uncle Ben is there with his giant footprint — the largest balance sheet on the planet — ready to act,” says Swanson.
Meanwhile, stocks that make up the S&P 500 index now trade at about 13 times this year’s expected profits. That is not bad by historical comparisons and many large stocks offer dividend yields that approach or exceed 2 percent.
A company with a stock trading at 13 times profits earns about 7 percent for investors when it hits its earnings forecasts. A cash dividend makes those stocks even more attractive compared with Treasurys. Of course, unlike stocks, that 10-year Treasury note yielding just 1.5 percent guarantees the full return of the investment in a decade.
The extreme economic portraits painted by the stock and bond markets are both exaggerated. Those markets are measuring different things and are distorted by the powerful influence of the Federal Reserve.
The economy isn’t falling apart, but there are few reasons to be very optimistic. You can decide if that’s the good news or the bad news.