A Challenging Narrative
Stocks may be attractive when compared to bonds. But there are reasons to doubt the low yield, buy stocks narrative.
There is a wonderful narrative going around Wall Street that goes something like this:
“Sure, stocks look pricey but with bond yields so low, they’re still a good bet.”
On the one hand, this makes sense. Who wants to invest in bonds or put money in the bank when interest rates are so low? Who wants to grab a 0.6% yield when you could make 10% or more in the stock market?
But herein lies the first mistake.
#1 There’s a reason yields are low.
The reason why bond yields are so low in the first place is because they need to be. The economy has been hit so hard by the pandemic that policymakers are doing all they can to keep things moving.
The fact that yields are so low, therefore, is an indication that economic growth is going to be lacklustre for some time.
In turn, the likelihood of stock markets outperforming is diminished, since stocks cannot prosper without reliable economic growth.
Sure, some stocks will see short-term benefits. We have already seen that first hand with the likes of Amazon, Apple, Wayfair, Peloton, Home Depot all seeing robust revenue growth thanks to stay-at-home measures and other pandemic induced events.
However, revenue growth has mostly come in the second quarter and beginning of summer. This is a time when policymakers were at their most aggressive and benefits checks were free flowing.
Since then, benefits have been reduced and so the prospects of keeping up the recent performance is made more difficult. Moreover, as winter approaches, there is sure to be a second wave that will put more strain on consumers.
But despite these concerns, many stocks are still trading at high multiples suggesting that investors believe earnings strength can continue at the same pace.
Which brings me on to the second flaw in this narrative.
#2 Yields don’t affect earnings (much).
It really doesn’t matter how low bond yields are, if a company is trading at 30 times earnings it will still take 30 years to make your money back on that investment (assuming earnings stay the same).
In other words, bond yields don’t matter much if a stock is priced so excessively that it cannot guarantee a profitable long term return.
The danger here is missing the forest for the trees. Yes, stocks will usually outperform a 1% bond, but if that stock is so richly valued at the time of purchase, it will not necessarily turn out that way.
With so many internet and technology stocks now trading at 40, 50, 60 times earnings, the most likely scenario is that many of these stocks will significantly underperform in the months and years ahead.
But our narrative is still missing one key ingredient. What if inflation was to unexpectedly move higher and bond yields were to step up?
#3 No one can predict interest rates.
You see, another flaw with this narrative is the belief that not only are interest rates low, they are going to stay low for a considerable amount of time.
Currently, there is not a soul on Wall Street (or FinTwit for that matter) who thinks bond yields could go up. So it seems everyone is now an expert on interest rates.
But, wait. Last time I checked I didn’t find anyone on this planet who has ever been able to predict inflation or interest rates with any certainty.
Can inflation reignite?
You could say that the low inflation of recent years has been partly driven by new technology. Online marketplaces, services and apps (with their low cost structures) are able to keep prices down. Just think of the ebook which is produced at a minuscule cost when compared to a traditional paperback.
But maturing tech companies are just as able to raise prices as any other company in the economy. In fact, the last time I looked, the price of an ebook on the Amazon kindle store was about 3 times higher than this time last year.
Now I’m not saying that inflation will definitely rear its head or that bond yields aren’t important.
But believing the stock market will continue higher because yields are so low is a narrative that has to be questioned.