Investment Outlook for 2011 – Equities vs Bonds

The more things change, the more eerily familiar they seem to be. It has been months since I updated the blog; ignoring the daily drivel proves useful as the stock market rally have stayed on course. Will 2011 bring more riches for investors? I am cautiously optimistic about the investment outlook, especially equities, though it could be a rough ride with stock markets nearing a major crossroad.

Stock market indices have run up in a hurry in 2010, delivering double digit growth. Just yesterday, the S&P 500 came up to 1286 which is near my target of major resistance at 1300. It could turn down abruptly from here or overreach at 1320 by end January but one thing is certain, there is limited upside in the short term. I will not advocate any more investments at such levels but whether we should sell is another issue to look at in a while.

To be sure, there are enough fuel for the next leg of stock market rally. Companies are reporting heady profits and sitting on cash, the US economy is recovering and unemployment figure dropped to 9.4%. To further whet your risk appetite, 2011 is the 3rd year of US Presidential term, a traditionally bullish period rewarding investors with positive returns since 1939.

But there is always an element of risk when we are investing. You should never invest more than you can afford to lose. This principle will come in handy in the next few weeks. Bullish sentiment is on the rise, which is an useful contrary indicator to tell us about an imminent correction.

The US housing market is still in doldrums, banks are still under-capitalized and burdened by toxic assets. Europe debt crisis is far from being resolved while the good credit of US is at stake if the debt ceiling is not raised. Interest rates could be raised soon which could derail the weak recovery of the global economy.

Yes, there are enough dark clouds to make us grumpy. But given a choice between investing in bonds or equities, I will choose the latter. While bond issuers had a bumper year by raising capital cheaply, investors got the short end of the stick with paltry yields. It barely covers inflation and we have to contend with bond prices tumbling as much as 30% (terrible for a “risk-free” asset) if contagion effects are not dealt with.

Despite the Fed’s efforts at keeping yield low, the 10-year Treasury note has risen to around 3.35% from 2.48%. According to the WSJ, the price of 10 year notes has dropped 5.5%, and 30-year bond (more sensitive to yield changes due to longer duration) has fallen by more than 7%. That is only the beginning of a potential meltdown.

Bad Year for Bondholders

I have nothing against bonds, especially Treasuries. They are in most circumstances risk free; if you hold to maturity, you get back your principal plus coupon payments. Sweet! It used to be easy for uneducated and risk averse investors like retirees to pick AAA bonds and sleep soundly at night, but not these days.

Currently, the biggest risk of default come from sovereign debts in Europe. The full brunt of this crisis has not been felt and will not be confined to Europe alone. Major banks with huge exposure may bite the dust and set off another confidence crisis and credit crunch similar to that after Lehman Brothers collapse. Yields will rise making it tougher for profligate states to raise money. Bond prices will also tumble affecting current bondholders.

After the rescue of Greece and Ireland, investors heaved a sigh of relief but Portugal and Spain are now tottering precariously. It is a matter of time before they also test the strength and resolve of the monetary union. Spain’s debts is no trifling matter, easily eclipsing Portugal’s, and it doesn’t look like the Spaniards will react well to austerity measures as they are already staring at a daunting 20% unemployment rate.

A bright spot is that the richest euro nation, Germany, has rebounded strongly with its economy growing at 3.6% (its biggest increase in 20 years). Retail sales, business confidence and exports are also improving. However, the Germans are in no mood to celebrate with more bailouts to dish out.

In February, German courts will rule on the constitutionality of bailouts. A negative decision could unleash mayhem on sovereign debts and affect market sentiment. Even if the decision is favorable, state elections in Germany this year could increase uncertainty of bailouts as German taxpayers are mostly dissatisfied with indulging their spendthrift neighbors.

Municipal bond is another hotspot. US local governments had put off tough decisions which leaves the fiscal situation straining at the seams in 2011. California, Illinois and New York are struggling with budget deficits. There are no easy options. Balancing the budget by cutting expenses will put many government employees out of job while raising taxes will incur the wrath of taxpayers at a time when they are trying to make ends meet. Unless the federal government steps in or more investors take on credit risk, else a default and haircut for current bondholders is certain.

Bondholders are also feeling the heat from a potential hike in interest rates. That is looking increasingly likely with inflationary pressure mounting. Despite Ben Bernanke’s insistence on deflation, food prices are being ramped up across the globe especially in the second half of 2010, thanks to QE II and volatile climate which saw several food producing regions battling drought, wildfire or floods.

The UN Food and Agriculture Organization’s (FAO) index of world food prices has risen 32%. And the Economist magazine shows the commodity-price dollar index for “all items” has increased significantly by 30.6% year-over-year. Food itself is up 24.9%.

Food is a basic necessity for human survival; if prices are left unchecked, it is a recipe for social upheaval. As the poor spend more of their income on food, when prices go up 30% to 50%, it could be a matter of life and death for peasants while the rich will not blink an eye spending an extra few hundred dollars.

There are a few ways to deal with inflation, one of which is to ensure wages move in tandem. China has raised the minimum wages in Beijing by 20%, the second such rise in barely six months. Clearly, the scepter of social unrest is weighing heavily on the Chinese government.

I am all for raising minimum wages, but the middle class is likely to stagnate. Despite higher corporate profits, employers still prefer to seek cheap labor by outsourcing jobs or relocating factories instead of rewarding their employees. In any case, increasing wages is not tackling inflation at the source. End of the day, we only end up chasing prices higher which leads to more inflation.

To combat inflation, a hike in interest rates is most effective. Central banks, including the Federal Reserve, have a primary mandate to ensure price stability. Once you lose the mandate, unhappiness can spill onto the streets in the form of strikes and riots. Higher political risks is bad for countries which depend largely on foreign investments.

It is too early to judge if Ben Bernanke is right to prop the housing market and stabilize the banks with 0% short term interest rates while driving long term interest rates down through purchase of Treasuries. But his actions have caused runaway commodity prices which will certainly sap the life out of the US economy. If input prices rise indefinitely without a corresponding increase in output prices because consumers either refuse or cannot stomach the increase, something is gonna give.

I read with a tinge of regret that Paul Volcker has left the Obama’s team of economic advisors. We will need him because the Federal Reserve is not known for interfering with the market unless they have a crisis on hand, hence we can rest assured that inflation will not be acknowledged till CPI numbers take on epic proportions.

Back in 1979-1983, the US faced high inflation and stagnant economic growth. Federal Reserve chairman Paul Volcker announced that he will stop at nothing to break the back of inflation and proceeded to jack up interest rates to 15%. Naturally, the US went into a recession but growth resumed in 1983. More importantly, Volcker set the foundation for a strong US economic recovery.

Well, double digit interest rates is going to cause a lot of pain for debtors who have to make higher interest payments. Bondholders also suffer from a fall in bond prices and lose the opportunity cost of achieving higher yield.

However, I doubt such high interest rates will happen today, even if a gradual and moderate increase is inevitable. The US has a $14 trillion debt and counting. Paying off 11% could render the US insolvent as the government receives only $1.45 trillion in income last year. There is also the bloated housing market and banks’ losses from mortgage loans to consider in any massive rate hike.

Turbulence in Bond Market is Good News for Equities

The stock market rally has been impressive since coming off March 2009 lows. It is noteworthy that the crowd has not even got in on the action. Investors have been parking their idle cash in bonds, despite sovereign debts hogging the headlines. Bond mutual funds and municipal bonds received about $267-billion in net new cash flow in 2010, while stock funds lost almost $30-billion.

There is still a lot of cash sitting on the sidelines and if they pour into the stock market upon the next correction, I am optimistic about the SPX clearing 1300 and making an assault on 1500 by end of the year. Any talk of a bubble is getting ahead of ourselves unless a sustained net flow of funds into equity markets appears. More importantly, we need a mania from the crowd, usually seen in an IPO fever where investors go into a frenzy over quick and easy money from IPOs without the need to consider fundamentals (Facebook’s IPO in 2012 will be interesting).

I agree that stock valuations are not cheap currently – dividend yields are 2% and PE ratios above 20 on the S&P 500. But neither have stocks become so expensive that we should start selling. If we take an optimistic approach and consider forward earnings, valuations of most blue-chips are in fact fairly priced.

Besides undeployed funds, stock markets can get a further lift from a flight in bond markets. For the time being, investors’ nerves are calmed by Portugal’s successful bond auction. But it should be noted that China and Japan have given a big helping hand. Japan is in a bit of fiscal mess themselves and China can be capricious in dispensing favors so there is no guarantee on the outcome of future bond auctions.

Equities will be the major beneficiary of hot money flow rather than commodities which have already run up substantially. Further upside could affect consumers’ demand and threaten a weak recovery in the global economy. The risk profile of bond investors also favor defensive equities over the more volatile commodities market.

Properties are also likely to take a backseat after the slew of cooling measures announced by governments. Housing is a politically sensitive issue when young people wanting to start families are priced out of the market. China is stepping up efforts to curb speculation and ensure affordable housing for the masses. Supply is not causing sky-high prices though. A search on Youtube videos show many empty malls and condominiums in China. The number of vacant properties is not surprising when a 15-storey hotel can be built in 6 days. Apparently some investors are happy to just let their assets collect dust and wait for prices to appreciate.

The Federal Reserve is also expected to maintain a weak US dollar to boost exports and “inflate” debts away. That will benefit stock markets as a weak dollar forces people to invest rather than keep money under their mattress. The US dollar could decline to low 70s in the next leg of the stock market rally.

No matter what monetary policy Ben Bernanke adopts, the US dollar will be trashed in the short term. More Quantitative Easing will give rise to hyperinflation and devalue the dollar, while raising rates too high will see US expends all its income to pay interest costs, eventually bankrupting itself and destroy the dollar. Once the US economy gets back on a firm footing, the dollar will regain its strength but that is not expected to happen till 2014.

While I am optimistic about the stock market due to favorable fundamentals, it doesn’t mean we throw caution out of the window. I favor equities making new highs but it bears remembering that we are in a secular bear market. This rally has been powerful because we came off a low base of more than 50% retracement from 2007 highs but the cyclical bull will end at some point.

Hence, there is a second scenario that stock markets will have a deep correction of at least 25% and go into a lengthy consolidation. SPX could fluctuate around SPX 950-1000, a comfortable equilibrium over the last decade. In this case, we should not get overly bullish nor discard our stock holdings. If you bought into defensive and dividend paying stocks, you just need to wait patiently for the secular bull to arrive and deliver lucrative returns, most likely in 2015.

We will get better clarity of the situation come April. Always remember to prepare for the worst and hope for the best. But this time, the worst will not include a stock market crash below SPX 666. If it does, we are in a lot of trouble because the Federal Reserve has not much ammo left to revive the market after setting interest rates at near zero and printing crazy amount of money. However, we could test 850 before ending the secular bear decisively.

Buy some Gold As a Hedge

Gold has fallen from its peak of over $1400 to $1360 recently. There are many reasons for a correction in gold prices, US dollar rally, profit taking, easing of geopolitical tensions, recent sale of gold by IMF, etc.

You may be tempted to sell gold during this correction but preserving a 10-15% allocation in the portfolio is actually prudent. Since 2002, gold climbed from $275 an ounce to new highs of $1,400. There is no indication of a long term reversal just yet. In fact, the sparkling performance in gold will continue onwards to $1800 with weakness in the US dollar and a trigger happy Ben Bernanke when job creation stalls again.

Gold has always protect our wealth when inflation is rampant. So keep your gold and buy into the stock market on any sizeable correction. That is all for today, hope you guys have a great year ahead!

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