In July, when the Dow Jones industrial average was still stuck below 12,900 and investors were seeking safety in bonds, Seth J. Masters made a startling argument.
Masters, chief investment officer at Bernstein Global Wealth Management, said people were so traumatized by the financial crisis that they were seriously underestimating the stock market. The chances were quite good that by the end of the decade, the Dow would rise more than 7,000 points and reach 20,000, he said.
In some important ways, he said, stocks had become safer than bonds. ‘‘This argument may seem provocative,’’ he said back then. ‘‘But that’s only because market conditions are so unusual, and so many people have become so pessimistic.’’
Last week, Masters made essentially the same argument, but it sounded much less provocative. After months of soaring prices, new stock market records, and minuscule bond yields, it may even be the Wall Street consensus.
“It seems we’re somewhat ahead of schedule, but I think we’re still on track for Dow 20,000 by the end of the decade,’’ Masters said last week. ‘‘The odds have just gotten better.’’ And despite the stock market’s recent meteoric rise, he said, stocks still look relatively cheap, certainly compared with bonds.
‘‘It’s not that the expected return on stock right now is really that high,’’ he said. ‘‘It’s that the return on government bonds is indubitably very low.’’
That unfavorable verdict on bonds is no accident. In a sense, it’s the policy of the Federal Reserve. Ben S. Bernanke, the Fed chairman, says he is trying to make traditionally riskier assets like stocks relatively attractive, increasing investors’ wealth and in that way stimulating the economy.
As far as the bond market goes, the yield on a benchmark 10-year Treasury note was only 1.5 percent in July, and it is about 1.9 percent now. To put those yields in perspective, the average for 10-year bonds since 1962 has been more than 6.5 percent, according to quarterly Bloomberg data. In other words, since July, bond yields have risen by the tiniest bit, and they remain extraordinarily low, on a historical basis.
For bond investors, particularly retirees, these low yields pose a serious dilemma. ‘‘This situation creates great problems for people trying to live off the income they can get from bonds,’’ Masters said.
For now, it’s worth noting that the problem for income-seekers will sort itself out eventually when bond yields rise and prices fall. But that shift is likely to inflict considerable harm on unwary investors.
That day of reckoning keeps receding, however, as global economic growth and inflation remain constrained. That alone tends to keep bond rates low. Furthermore, government spending cuts like the budget sequestration in the United States have reduced economic growth substantially, in the view of the International Monetary Fund and other forecasters.
And as long as unemployment is high and inflation is low, the Fed says it will continue to keep short-term interest rates near zero — and buy $85 billion a month in long-term bonds and other securities. Other central banks have made similar promises. At least for a while, then, historically low interest rates seem likely to persist, for short-term bills as well as for long-term bonds.
The likelihood of low bond yields helps explain the relatively high stock market returns expected by Masters. And a new study suggests that those yields are the main factor behind the bullish stock market consensus of financial analysts on Wall Street and in academia.
Fernando Duarte and Carlo Rosa, two economists at the Federal Reserve Bank of New York, described their study in ‘‘Are Stocks Cheap? A Review of the Evidence,’’ a posting on the New York Fed’s Liberty Street Economics blog. They analyzed 29 separate economic models and found that most predicted extremely high stock returns for the next five years. Why? There are many wonky reasons but in the end, they said, it is ‘‘mainly due to exceptionally low Treasury yields at all foreseeable horizons.’’
This may be the prevailing view among professional analysts, but mutual fund flows suggest the great mass of investors have not yet embraced it. Over the last seven years, according to calculations by Bank of America Merrill Lynch, mutual fund investors worldwide have poured a net $1.1 trillion into bond funds, and taken $900 billion out of stock funds.
In the United States, investors began moving some money back into stock funds in January, but not all that much. So far this year, they poured significantly more into bond funds — $85.4 billion into bonds compared with only $73.2 billion into stocks, according to Investment Company Institute estimates. And in the week ended May 1, the institute’s preliminary numbers show, the outflow from stock funds had resumed, with a net withdrawal of $4.4 billion.
Clearly, individual investors are still holding a relatively high allocation of fixed-income securities in their portfolios. That suggests that there is plenty of fuel for further stock market rallies.
None of this implies that high stock market returns are a sure thing, however. To the contrary, Masters said: ‘‘I don’t think the path to Dow 20,000 will be linear — and it certainly won’t be a straight line up. There will be declines, you can count on that.’’
Duarte and Rosa wondered whether market returns were predictable at all, saying, ‘‘The jury is still out on this one, and the debate among academics and practitioners is alive and well.’’
Masters noted that his forecast assumes economic growth of more than 3 percent this year and comfortable earnings by American companies. Those assumptions — and many others — could lead investors astray. Like nearly everybody else, his firm assigned a low probability to an event like the financial crisis. It could well miss another catastrophe, and so he advises a cautious, diversified approach to investing.
With those caveats, he said, he had used all of the information available to calculate the prospects for the market. ‘‘I still think that the best forecast for the rest of the decade is Dow 20,000,’’ he said.