The Stock/Bond Disconnect

August 13, 2010

Investors’ on/off love affair with risk assets has characterised financial market behaviour
all year. Indeed, infatuated portfolio managers have begun to court stocks once again,
and stock prices have climbed almost ten per cent from their lows in early-July, as
impressive second-quarter earnings reports soothed equity investors’ double-dip fears.
Meanwhile, fixed income investors are having none of it and continue to gravitate
towards the relative safety of Treasury securities; the strong demand has pushed ten-
yields down to just 2 ¾ per cent, under the rate that was registered when stock prices
bottomed 17 months ago.
The bond market’s pessimism is corroborated by the macroeconomic data while, the
stock market’s relative optimism has been validated by the bottom-up evidence. The
signals emanating from each market stand in sharp contrast to one another, so which
message should be believed?
Ten-year Treasury yields have recorded a meaningful decline from their recent high of
slightly more than four per cent in early-April, when financial markets were presuming
that the U.S. economy would enjoy a typical ‘V-shaped’ recovery. The macroeconomic
data has consistently disappointed since that time, revealing that the fledgling recovery is
anything but normal. The hard numbers for economic activity and employment creation
have fallen short of expectations, while numerous survey indices continue to be
indicative of an economy that is mired in recession.
The pace of economic growth slowed to below 2 ½ per cent in the second quarter, and the
level of economic activity remains below the pre-recession peak. A typical post-war
recovery expands at a more than six per cent annual rate one year into the recovery, and
stands eight per cent above the prior business peak 2 ½ years after the recession began.
Furthermore, the economy grew by less than half of one per cent if the substantial
contributions from inventory accumulation and government spending are excluded, and
would have been close to zero but for the temporary boost to residential investment from
the homebuyer tax that has since expired. The bottom-line is that the average 1.2 per cent
growth in real final sales since the economy bottomed last summer confirms that this is
the most tepid recovery in post-war history.
Labour market data paint a similar picture. The establishment survey data contained in
July’s employment report revealed that 131,000 jobs were lost last month, more than
double the consensus estimate. Additionally, the numbers for the prior two months were
revised downwards by 97,000. A typical post-war recovery has not only recovered all
jobs lost during the prior downturn at comparable points in the cycle, but has created an
additional one million jobs 2 ½ years after the recession began.
The household survey, which has a more expansive scope and tends to be a leading
indicator of payroll data at turning points, showed that 159,000 positions were shed last
month following contractions of 35,000 and 301,000 in May and June respectively. The
unemployment rate remained unchanged at 9 ½ per cent, but only because the labour
participation rate dropped to its lowest level since 1984. Roughly 45 per cent of the
unemployed are out of work for more than 27 weeks, a post-war record, while broader
measures of joblessness reveal that 16 ½ per cent of the workforce is currently
unemployed. The evidence is clear; the labour market is not recovering but stagnating.
Surveys of consumer confidence and business optimism also side with pessimistic bond
investors. The University of Michigan’s consumer sentiment index stood at 67.8 in July,
as compared with an average of 74 during recessions and 91 in economic expansions.
The Conference Board’s consumer confidence survey reads 50.4 for July, less than half
the reading that is typical in an economic expansion, and 20 points below the average for
recessions. The National Federation of Independent Business’s survey of small-business
optimism came in at 88.1 for July versus an average of 92 during recessions and 100 in
expansions. The survey evidence is hardly indicative of a self-sustaining recovery.
The macroeconomic evidence clearly sides with the risk-averse bond investors, and not
with the risk-loving equity bulls. The diehard optimists can point to another exceptional
earnings season, as more than half of the companies that have reported to date beat
consensus expectations by more than one standard deviation. Twelve-month trailing
earnings have climbed 85 per cent from their trough last autumn, and estimates for the
current calendar year continue to edge higher.
Although corporate America’s performance has been nothing short of impressive, almost
all of the three percentage point improvement in return on equity has been driven by
margin enhancement, with only a modest uptick in asset turnover – sales per dollar of
assets – from the recent trough. Trailing twelve-month sales remain 14 per cent below
their prior peak, an unprecedented post-war development, which helps explain why
strong profits are not translating into significant job hiring or capital spending
programmes. The record levels of cash sitting on corporate balance sheets is cited by
many as a bullish development, but perhaps it reflects increased caution in a difficult
growth environment and/or increased liquidity demand given the possibility of a further
reduction in the supply of credit from an already fragile banking system.
Investors should note that the pessimistic signal emanating from the bond market is far
more convincing than the perennial optimism espoused by the equity bulls. Furthermore,
the historical record shows that bond yields lead stock markets and not the other way
around. The recovery is extraordinarily fragile and the economy is just one recession
away from deflation. Take note.

www.charliefell.com

The views expressed are expressions of opinion only and should not be construed as
investment advice.
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