David Joy: Stocks vs. bonds: which camp is right?

Stocks closed at another new high last week. The S&P 500 added 1.2% to bring its year-to-date gain to 4.1%. Also last week, the yield on the ten-year Treasury note fell five basis points to 2.48%, after having fallen to as low as 2.44% at mid-week.

And therein lays the dilemma for investors. Which asset class is correctly foreshadowing the future? Is it stocks, which clearly seem to suggest a future of firming economic activity and growing corporate earnings, or is it bonds, which seem to project a future of sluggish growth, low and perhaps falling inflation, and deflating risk assets?

When viewed as a choice this stark, investors become nervous. Those in the more optimistic camp are forced to worry about what it is they are missing. Bond yields are the 800 pound gorilla in their room and they wonder what it would be telling them if it could speak. They find it impossible to ignore its existence, while hoping its presence is benign.

The worry stems from historical experience, which tells us to ignore the message of the bond market at our own peril. Bond yields may not signal when optimism is too high, but it has in the past done a pretty good job of telling us that not all is well.

For those who take at face value what the bond market seems to be saying, they may be feeling a certain sense of vindication. At the start of the year the overwhelming consensus expectation was that bond yields would be rising as the economy gathered pace, opening diverging return experiences between stocks and bonds.

And while stocks are generally following the script, although not in a particularly decisive way, bonds are clearly not. At the start of the year, the yield on the ten-year note was 3.03%. The yield on the Bank of America Merrill Lynch High-Yield Master II index was 6.39%, and is now 5.85. The Barclays U.S. Treasury 7-10 year index has a year-to-date total return of 5.5%, while the 20+ year index has a return of 13.4. The Barclays U.S. Corporate High-Yield index has a year-to-date return of 4.6%, with a similar dispersion of returns by maturity to Treasuries.

But neither can bond investors enjoy a sense of complacency. They worry that the growth acceleration story may happen eventually, pushing inflationary pressure and the demand for credit higher. They worry that monetary policy, at least in the U.S. and U.K., will eventually be changing direction. And they worry that the decline in yields may be due more to technical factors and the global thirst for yield than a future of slow growth, especially in light of credit spreads which refuse to widen.

Binary outcomes are always preferred. It is a lot tidier psychologically to have two choices, place your bet, and adjust if you have to. Having more than two choices is messier. But that is exactly where we may be in this cycle. Is it possible that stocks and bonds are both correct? Is it possible that growth is improving against a backdrop of still excess capacity, abundant liquidity, low inflation, and a voracious appetite for yield? The short answer is yes, that is certainly possible. Such conditions may not persist indefinitely, but they can persist for a while longer.

But if that proposition is correct, it does not relieve us of the burden of worry. No condition stays static. As always, the data will tell the story. Here’s to placing a bet that the growth outlook is improving. Here’s to also owning a comfortable complement of good quality intermediate bonds in case it is not.

Disclosure
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.

Bank of America/Merrill Lynch High Yield Master II is an index of high-yield corporate bonds which measures the broad high yield market.

The Barclay’s U.S. Treasury 7-10 year index measures the performance of U.S. Treasury securities that have a remaining maturity of at least seven years and less than 10 years.

Barclays Capital U.S. Corporate High Yield Index: Is an unmanaged index that is comprised of issues that meet the following criteria: at least $150 million par value outstanding, maximum credit rating of Ba1 (including defaulted issues) and at least one year to maturity.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

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