Over the past couple weeks we have received some noteworthy commentary from legendary bond manager Bill Gross, co-founder of Pacific Investment Management Co. (which manages a trillion dollars in fixed income assets).
The commentary is noteworthy because Gross seems to be doing the opposite of "talking his own book." On March 25, Gross told Bloomberg radio that "bonds have seen their best days" following a 30-year bull market in bonds and a decade in which bonds handily outperformed stocks. In the same week, Gross told CNBC that, all things considered, he now favors stocks over bonds. And finally, Pimco announced in December that it would begin offering stock funds for the first time.
Is Gross trying to tell us something?
If Gross is right, it seems that everyone else must be wrong.
According to Bloomberg, "Bond mutual funds in the U.S. attracted $409.4 billion over the past 14 months, according to Morningstar. Stock funds gathered $11.7 billion during the same period." Investors continue to seek the relatively safety of bonds after being stung by sharp losses in the equity markets from late 2007 to early 2009. The surge in bond buying has led to a sharp contraction in yield spreads on all kinds of fixed income securities ("Yield spread" refers to the difference in yield between differing credits or different types of securities. Most often it refers to the yield difference between a specific bond and the US Treasury Note of similar maturity). And the yield on "risk-free" Treasury bonds remain very low thanks to scant evidence of inflation and the Fed's monetary policy, including quantitative easing.
So has the big opportunity in fixed income expired?
Gross seems to think so, and we tend to agree. Given the extraordinary amount of government spending and soaring federal budget deficits, we believe inflation is likely to rear its ugly head within 2-3 years. Moreover, the Fed's $1.25 trillion program of buying agency, unsecured, mortgage-backed, and Treasury securities, which has been highly supportive of bond prices, ends today. As a result of these escalating risks, we are keeping our bond maturities relatively short. We believe bond investors will have a chance to reinvest maturing bonds at higher yields in the coming years. At the same time, we continue to favor reasonably-priced, high-quality blue chip stocks over bonds (for longer term investors). Notwithstanding the massive rally in stocks since the March 2009 lows, there are reasonable values to be found in high-quality stocks.
Having said all that, we would caution investors to reign in their expectations for stock returns in the years ahead. We expect stocks to produce 7-8% returns over the long-term, which we arrive at by assuming a stable P/E multiple (~15x), 5-6% earnings growth and a 2% dividend yield. While lower than the returns that stocks have historically produced over the long-term, these returns compare favorably to 4% bond yields. We would also remind our readers that our prognostications about investment returns, like those of Bill Gross, are long-term in nature and are subject to a high degree of variability from year to year. As long-term investment managers, we seek to exceed our benchmarks for any investment cycle, which can be anywhere from 4-7 years.
Looking at the investment landscape over a shorter-term horizon, we would make the following observations:
While we acknowledge that the 11K level on the Dow may be a psychological barrier for some, we don’t place any particular significance on reaching 11K. We think (and hope) that the market will see smooth sailing through quarter-end as managers window dress. The next big test will be on Friday when we get the March employment report. Expectations have been rising for new job growth with the latest consensus at nearly +200,000. Anything but a strongly positive number will surely risk some kind of a sell-off. Today's ADP employment report produced some anxiety about Friday's government report.
The dollar has continued to strengthen.
This is fortunate for the Fed because it is disinflationary (imports are cheaper). We believe the dollar's strength simply reflects the weakness in the rest of the world. So while fortuitous for now, we would not be placing huge bets on the dollar from these levels. Absent big problems in Europe and elsewhere, the dollar would surely be weaker as a result of all the money created by the Fed. In other words, we don't believe the Fed can rely indefinitely on a stronger dollar to help control inflationary pressures.
As for gold, we recognize the value of gold as an inflation hedge.
However, we think a dramatic increase in inflation could still be a couple years off. With capacity utilization low and unemployment very high, we do not see the imminent risk of run-away inflation. As mentioned above, we do believe the risk of higher inflation down the road is very real. However, following such a dramatic rise in gold to date, we would be reluctant to allocate new money on the premise of an imminent surge in inflation.
With regard to our stock allocations, we continue to favor Healthcare, Technology and Consumer Staples. These sectors, especially Healthcare and Staples, have not participated as much in the last year's rally. As investors begin to more fully appreciate the continued risks in the economy, we believe money will rotate into these more defensive sectors and out of the highly cyclical sectors such as Financials, Energy and Consumer Discretionary. We are underweight Energy because we believe the global economic recover will be a slow one, especially in the US. We continue to worry about 10% unemployment, stagnant wage growth, high consumer debt levels, a lack of bank lending, and what we see as a likely resumption of downward pressure on housing prices. Emerging markets are bouncing back more quickly, but the US still accounts for a large chunk of global energy consumption.
Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.