Rally Stalls On Deflation Fears

8/16/2010


A drop in Treasury-bond yields has heightened worries regarding deflation. The Federal Reserve, acknowledging that growth has slowed, announced plans to reinvest its proceeds from expiring mortgage-backed securities in Treasury bonds — a move that could help keep mortgage rates low but one that is unlikely to do much for investor confidence.

We’re holding a bigger-than-normal cash position, with 25% of our Buy List and 28.7% of our Long-Term Buy List in a short-term bond fund. Also, we’re watching the averages for a breakout above 11,205.03 in the Dow Industrials and 4,806.01 in the Dow Transports — or a breakdown below 9,686.48 and 3,906.23. Finally, we’re looking for opportunities one stock at a time.

Stocks versus bonds

With inflation at a 44-year low and the Fed affirming Aug. 10 that it intends to keep short-term rates “exceptionally low” for an “extended period,” yields on two-year Treasury notes have dropped to a record low below 0.5%, while 10-year Treasury yields have moved to a 16-month low near 2.7%.

By comparison, the dividend yield on the Dow Industrials is 2.6%, meaning investors don’t need to sacrifice much income for participation in the dividend growth and share-price appreciation that blue-chip stocks typically provide over a 10-year period.

IBM ($132; IBM) recently sold $1.5 billion of three-year notes at a 1.0% interest rate, well below the dividend yield of 2.0% on IBM’s stock. McDonald’s ($73; MCD) recently sold 10-year bonds at 3.55%, only slightly above the 3.1% dividend yield on McDonald’s shares.

Of course, IBM and McDonald’s bondholders will get par value for their bonds at maturity if the companies are able to pay, while stockholders get no such guarantee. After a decade of negative stock returns and huge swings, many no longer see the point of taking a risk on the stock market.

From a long-term perspective, the lack of enthusiasm for stocks is good news; historically, buying shares has been a good idea when investors’ ardor for stocks is at a low ebb. The bad news is threefold:

Stock-market enthusiasm could wane further in the near term, especially if the averages’ July lows are violated.

Profit estimates are likely to drop if U.S. economic growth decelerates further. While a few analysts have trimmed estimates, the consensus still projects per-share-profit growth for the S&P 500 Index of 35% for 2010 and 15% for 2011.

Dividend payments are likely to suffer if the U.S. follows Japan into a deflationary malaise. A high dividend yield does not ensure positive long-term returns. Ultimately, a stock is valued based on the underlying earning power of the company.


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