Bond Rally Lifts Bond-Like Stocks
If something cannot go on forever, it will stop. So says Stein's Law, an obvious but useful reminder for trend followers.
For bond investors, the question is when the downtrend in bond yields will end. The yield on the 10-year Treasury note reached an all-time low of 1.37% on July 5, extending a three-decade bull market in bond prices.
U.S. bonds still yield significantly more than those in Europe and Japan, where yields on many bonds have turned negative. Bond bulls expect foreign demand to sustain the downtrend in bond yields, with some predicting the yield on the benchmark 10-year Treasury will drop below 1% this year.
Others argue that the bond market is already in bubble territory, that a desperate hunt for income has pushed bond prices well above any notion of fair value. If central banks in Europe and Japan stop printing money to buy bonds, argue bond bears, a lot of investors will be trampled in the rush to the exits.
Equity investors are keenly interested in the bond-market debate, for much of the stock market's support has come from demand for bond-like stocks. While a record 63% of S&P 500 stocks pay a higher yield than the 10-year Treasury, according to Ned Davis Research, most of the buying has been concentrated in the safest income stocks.
In the 12 months ended June 30, the one-fifth of stocks with the highest yields in the broad Dow Jones U.S. Index outperformed the average stock in the index by more than 15 percentage points — their best relative performance since 2009.
The one-fifth of stocks with the lowest risk based on beta (a measure of a stock's sensitivity to stock-market movements) outperformed the average stock by nearly 19 percentage points — the best relative performance since our data began in 1992. Whether measured by beta or standard deviation, low-volatility stocks haven't been so expensive since 1992.
Stein's Law provides no guidance on timing. While valuations and recent performance suggest the rush into low-risk dividend stocks is nearing an end, nobody really knows.
Also, nobody knows what the end will look like. If investors begin to shop beyond the lowest-volatility stocks because the outlook for corporate earnings improves, we'd expect the Dow Industrials and Dow Transports to close above their respective April 20 highs of 18,096.27 and 8,109.19. If bond yields move higher on inflation concerns without much improvement in the pace of growth, we'd expect this winter's lows of 15,660.18 and 6,625.53 to be violated. For now, we intend to watch the averages and hold 80% to 81% of our buy lists in stocks.