 |
|
 |
Unappreciated Risk
By: Dr. Charles Lieberman
Date: 9/28/2009
Everyone, including many clients, seems to be talking about a possible selloff in stocks after a nearly 60% gain off the March 9 low. The hot question is whether the stocks might have run ahead of underlying fundamentals. While a setback for stocks could happen at any time, anticipating short-term market movements is inherently difficult. But, the longer-term and fundamentally based risk of rising interest rates ought to be a more significant concern. High-grade bonds, especially Treasuries, trade at artificially low yields. This implies large losses for a segment of the market that has attracted money seeking a safe haven.
The current focus seems to be whether the stock market rally might give back some of its recent impressive gains. This is actually the wrong question. Short-term fluctuations in stock prices should matter to day traders, not long-term investors. Anticipating short-term stock movements is an unrealistically difficult game, as most recently demonstrated by expectations for a setback that have been commonly expressed for the past several months. This concern rose even further prior to September and October, historically weak months. The more important question is whether an economic recovery is underway, which is a necessary condition to provide fundamental support for a stock market rally. If the economy is improving, stocks ought to begin recovering and it's just a quibble whether the market might be a bit ahead of economic conditions.
A more fundamental valuation issue exists in the bond market and it has received far less attention. The yield on the 10-year Treasury note is below 3.5%, far below fair value. Long-term Treasuries typically average 250 to 300 basis points above core inflation, implying a 5% yield would represent a fair or reasonable return. Actual yields are far below this value, reflecting the enormous liquidity introduced into the financial system by the Fed, as well as some residual flight-to-safety left in the system. Capital is still flowing into bonds and bond funds, reflecting the need for safe assets by retail investors. But when interest rates normalize, these high quality bonds will decline sharply in value. Corporations understand this and are issuing debt at record rates. Indeed, Treasuries are the only asset class with a negative return in 2009. While seeking safety, retail investors are going to be hurt longer-term, as stocks rally into 2010 (and beyond), while high-grade bonds take a beating. Investors are too focused on ephemeral issues, while failing to give proper due to longer-term fundamentals. This will be another costly mistake.
Download this article in PDF Format
|
|
