Bill Gross: Right on Bonds – Wrong on Stocks

Submitted by Wall St. Daily as part of our contributors program

Legendary bond investor, Bill Gross, just released his investment outlook for March. As always, it’s a loaded read.

Some have been hailing it as a warning against a bubble in high-yield corporate debt, which Gross expresses concerns about. But as you’ll see in a moment, the argument is more nuanced than that.

He also uses that information to conclude that we’re in store for years of low-equity returns – which is off point altogether.

First, let’s start with the bubble…

Gross’ Bet on a Baby Bond Bubble

Gross uses a recent speech by Fed Governor, Jeremy Stein, to investigate the question: “How can we tell when prices have reached a bubble level?”

The asset in question is high-yield corporate debt.

Now, it’s clear that “high yield” has become “not-so-high yield.” In the search for income, investors have bought up corporate bonds, driving prices up and yields down.

But while yields are lower than normal, we haven’t quite reached bubble territory.

Since 1996, high-yield (or junk) bonds, have returned about 5.99% more than government bonds, according to the Bank of America Merrill Lynch US High Yield Master II Index.

That average also includes the highly skewed period of 2008, when the spread reached as high as 22%.

Today the spread is down to 5%. Bubble territory? Not so much.

However, it is likely that bonds need to fall from here. So I’ll give him that much.

But his outlook on stocks is another story…

Why Stocks Should Still Rule the Day

Gross takes it a step further, citing a chart by the always-insightful Bianco Research. It shows the correlation between yields and equity prices.

Keep in mind that the yield line on this is inverted. So the chart suggests that if yields on corporate bonds rise (as we are predicting), then stock prices will fall.

Makes sense. You see, during times when money leaves corporate bonds, it can be a flight to safety that would end up in Treasuries. That money would similarly leave stocks, which backs up Bianco’s findings.

But here’s where I see the error.

That means stocks can also rise during periods of flat or rising yields.

If you extend the timeframe on that chart (as I’ve done below), you can see that while the correlation does hold true sometimes, it also clearly breaks down at other times.

The key to this anomaly? Risk.

Each time this has happened in the past, it’s been during periods of rising risk appetite among investors: after the 1998 Asian fiscal crisis, during the dot-com boom and during the subprime boom.

Yes, two of those scenarios were the building of bubbles. But all of them correlated with times when the investors’ hunger for risk rose substantially.

Why does this happen?

Well, when money leaves bonds during periods of heightened risk appetite, it goes into stocks. So in these scenarios, stocks don’t fall when corporate bond yields rise, as Bianco’s research suggests.

And I’ve been arguing that we’re undergoing the same thing right now. The risk-on/risk-off trade is dissipating. The financial crisis is over.  The European crisis is (mostly) resolved.

Simply put, the stock market is booming because investors aren’t afraid to take reasonable risks.

So far, this high-risk capital has been funneled into bonds because they have offered the highest return available for a while. That’s why corporate bonds are likely priced too high at this time. Prices will fall and yields will rise.

Only this time around, that money will flow into stocks, not Treasuries.

Bottom line: Don’t consider this bond mini-bubble to be a bad sign for stocks. I consider it just the opposite.