Monday Morning: Bonds a good bet to outperform stocks

Where are you more likely to earn a total return of 20% over the next 12 months, in stocks or in bonds?

That sounds like a silly question, given the historic return advantage stocks have over bonds. But considering the bad earnings reports pouring out of corporate America, it might not be so silly after all.

And a number of investment experts, including Pimco’s Bill Gross, have argued that bonds are likely to outperform stocks over the next 12 months.

According to Jim Floyd, senior researcher at the Leuthold Group in Minneapolis, the yield on high-grade 20-year corporates, currently at 7.12%, would have to decline only to 6% over the next 12 months to generate a 21% total return. That could beat the return on stocks over the next 12 months.

Given the Federal Reserve’s penchant for easing interest rates in the face of economic weakness and the current wide spread between corporates and Treasuries, it’s possible that the rate on long-term Treasuries, now at just over 5.5%, could drop to 5%. And the spread could narrow and bring about that 6% corporate yield.

So a 21% return on high-grade corporates, while not likely, is not out of the question.

Now, what would it take to earn a 21% return on stocks over the next 12 months?

As I write this, the Dow Jones Industrial Average is at just about 10300, and the Standard & Poor’s 500 stock index is at just about 1200. For the Dow to gain 21%, it would have to climb to 12463, a record high. The S&P 500 would have to climb to 1452.

Given the current state of the economy and corporate profitability, that’s hardly a sure thing.

For one thing, to achieve that kind of return, investors would have to see earnings and earnings growth rates climb from their current depressed levels, or price-earnings ratios would have to climb again, or both.

According to Mr. Floyd’s analysis, the normalized p/e ratio of the stocks in the S&P 500 is just over 26. For stocks to earn a 20% return over the next 12 months, the p/e would have to climb to almost 30, unless earnings exploded.

not enough

It’s entirely possible, perhaps even probable, that corporate earnings will improve over the next 12 months, but enough to justify an S&P 500 of 1452 and a p/e of 30? Hardly likely.

If bond yields drop to just 6.5%, from 7.12%, high-quality corporates will give a total return for the year of 14.4%, a pretty nice return. For stocks to earn the same return, the S&P 500 would have to climb to 1384 and have a p/e of 28.3, while the Dow would have to climb to 11832.

What about the risk? For an investor to suffer a loss on the long-term corporates in the next 12 months, corporate yields would have to climb to 8%.

Once again, that does not seem likely at present, given the weak state of the economy and the Fed’s stance toward cutting rates rather than increasing them.

The Fed’s easing efforts haven’t helped the economy much so far.

They won’t help as long as banks are reluctant to lend and companies are reluctant to borrow. Such reluctance is a result of sales and earnings weakness. In effect, the Fed is pushing on a string.

That’s why the Fed’s rate cuts so far have not helped the stock market. It is possible that further rate cuts will help bond prices before, and more than, they will help stock prices.

So bonds, especially high-grade corporates, deserve at least consideration for inclusion in many conservative portfolios.

Mike Clowes is the editorial director of InvestmentNews.