Listen up, Bond Holders: This Is a Wake-Up Call
Interest rates are going up, yet the stock market is taking it in stride. In fact, the Dow industrial average is hitting new highs.
Something wrong with this picture? Not at all. History suggests there’s still money to be made in stocks over the next year or so, even as interest rates rise.
Bond owners, on the other hand, are in for a rougher road. Investors who are heavy in bonds--and perhaps too light in stocks--need to do a portfolio reality check here.
On Tuesday, interest rates surged for a second day, responding to another batch of reports pointing to a strengthening economy. The 30-year Treasury bond yield, the benchmark for long-term interest rates, rose to 6.06% from 6.03% on Monday. The bond’s yield has now risen 0.27 percentage points since Oct. 15.
Shorter-term rates also have been climbing. The yield on six-month T-bills has jumped from 3.16% on Oct. 8 to 3.37% now.
Yet on Tuesday, the Dow industrials added 5.03 points to a record 3,697.64, and the Russell 2,000 index of smaller stocks also hit a new high, up 0.67 point to 260.17.
Usually, higher rates are bad for stocks, for obvious reasons. But that’s typically not true when the economy first begins to show some muscle after a recession. At that point, investors focus more on the excitement that higher corporate profits can generate for stocks and less on the negative effects of rising rates.
*
Charles Clough, chief investment strategist at Merrill Lynch & Co. in New York, believes we’re in that market phase right now. On Tuesday, he advised clients to change their mix of stocks, bonds and cash investments in favor of stocks--at the expense of bonds.
For investors who want a mix of income and growth in their portfolio, Clough suggested shifting from 45% stocks, 45% bonds and 10% cash to 55% stocks, 35% bonds and 10% cash.
The stock market, Clough said, now has an “earnings tail wind” pushing it in the wake of the stronger than expected third-quarter earnings reports from many key industrial companies. The upshot is that stocks “are likely to disconnect from bonds in the months ahead,” Clough said.
His argument has history on its side. As the accompanying chart shows, stocks have usually continued to advance well after short-term interest rates have bottomed.
Some experts, however, warn against stock investors getting too bullish at this point--and also against bond investors getting too bearish.
Marshall Acuff, investment strategist at Smith Barney Shearson in New York, says it’s reasonable to assume that the economy’s growth has picked up to a 4% real annualized rate in the current quarter, helped by booming home and car sales.
“But the question really is whether that growth is sustainable,” Acuff says. “Our opinion is that it is not.” Remember back a year ago, he notes: The economy also boomed late in 1992, only to slow markedly again in the first half of 1993.
That kind of stop-and-go growth has been the norm since 1991, a product of the slow wringing-out process of the 1980s consumer and business debt excesses.
So Acuff, who also recommends an asset mix of 55% stocks, 35% bonds and 10% cash, cautions against investors making too rosy an assumption about corporate profit growth next year, based on the economy’s current pace. If things slow again in the first half of 1994, profits could disappoint, pulling stocks lower. At the same time, an economic slowdown would bring new downward pressure on interest rates.
Even so, Acuff admits, with interest rates at 20- to 30-year lows and the economy gradually improving, the odds of making a lot of money in bonds from here aren’t great. “Longer term, stocks are always a better bet than bonds,” he reminds.
At financial advisory firm Brouwer & Janachowski in San Francisco, principal Kurt Brouwer agrees that long-term bonds are a dicey proposition now. But he also views the U.S. stock market as a high-risk bet, given the market’s historically high level relative to corporate earnings.
Brouwer’s solution: His clients’ assets are 66% in stock mutual funds, but one-third of that is in international stock funds, where Brouwer sees greater growth potential. Meanwhile, the other 34% of assets are invested in short-term bond funds, which provide an income component for Brouwer’s investors but at relatively low risk to principal should interest rates rise significantly.
*
What’s the average investor to do? Even if you’re heavy in bonds, don’t switch blindly into stocks. But consider this: If you’ve owned bonds (or bond mutual funds) for a long time, you’ve probably made a lot of money as interest rates have fallen over the past three years.
Just as stock investors take profits after long runs, it may behoove you to take out some (but not all) of your bond profits and invest in something more promising. And if you have suspected all along that you probably don’t own enough stocks for the long haul, moving slowly into conservative stock funds at this point may make very good sense--at least if history is any guide.
Stocks vs. Rates
Historically, the stock market has been able to ignore the first rise in interest rates during an economic recovery and focus instead on corporate profits. Here’s how the market has performed against rising rates in seven economic cycles.
Change in S&P; 500 stock index Trough in real after trough in short-term rates: short-term rates 6 mos. later 18 mos. later Nov., 1987 +5% +28% June, 1980 +17% +8% Feb., 1975 +7% +29% Jan., 1971 +6% +15% Jan., 1968 +6% nil Jan., 1961 +10% -5% May, 1958 +20% +31%
Source: Cowen & Co.
