Record-breaking US stocks are a sideshow next to bond bonanza
It is not only in the Olympics that records are being broken. On Thursday, all the three indices of the US stock market that have traditionally been most widely quoted set a new all-time high.
It was the first time that each of the Dow Jones Industrial Average, the S&P 500 and the Nasdaq Composite were simultaneously at a high since the very top of the internet boom back in early 2000.
But the multiple Wall Street records do not tell us as much as might be hoped.
First, as with any market index, we need to be clear about what each represents. Even though they continue to be widely quoted in the press, neither the Nasdaq nor the Dow tells us much and they are little used by investors. Neither is representative of anything much.
The indices are right, however, to indicate that stocks are on a tear. After several doses of volatility in recent months, animal spirits are back. And they are a good indicator of how much money it was possible to make. Index funds, which merely track an index rather than attempting to beat it, are hugely popular. In the case of the S&P, the world’s most followed index, the administrative costs are tiny. The return on the headline index is almost exactly what you could indeed have received by investing in an S&P tracker.
But how far have stocks really come since the top in early 2000? This is where it gets interesting.
Over the long run, the bulk of return from stocks comes from dividends, so we need to look at the index on a total return basis. Judged that way, the S&P has doubled since the top in 2000. It would have made you money.
But we need to take inflation into account. Do this, by dividing the rise in the S&P by the rise in the US consumer price index, and the returns drop to 40 per cent. In real terms, the S&P was still lower than at its 2000 peak 11 years later. But the exceptionally low inflation of the last few years means that the recent rally has meaningfully increased the buying power of those who held the S&P.
Now we need to consider the opportunity cost of holding stocks. They are risky and inflict volatility on you. Twice since 2000, the main indices have taken a terrible beating, in the crashes that started in 2000 and 2007. What could have been achieved in the much safer equivalent of government bonds?
The answer is stunning. When compared with long-dated treasuries, as measured by the Bloomberg EFFAS indices, the S&P has underperformed by almost exactly 50 per cent. In other words, buying stocks in 2000 would have made you money, but you would have made twice as much from bonds, with a much less bumpy ride.
Bonds flourish in an environment of low inflation, as this allows their fixed income payments to hold their value. They are also flattered by the 2000 starting point, when stocks were historically overpriced. But the bonds story goes further than that.
Bond yields — the effective interest rate paid by bonds, which falls as bond prices rise — have fallen to fresh historic lows this year. UK gilts, helped by the response to the Brexit referendum and the Bank of England measures that followed it, are among the best performing securities anywhere.
German, Japanese and Swiss bonds carry negative yields. The records for stocks are impressive; those for bonds are extraordinary.
Bond markets have real-world economic effects. Lower yields for the safest government bonds mean that riskier companies, and countries, can borrow for less. They have taken the opportunity to do so.
Higher leverage, for companies, helps boost earnings but also enhances risk for the longer term.
Most importantly, strong bond markets encourage investment in stocks. Once bonds become expensive, as they are now, it is easier to justify the risk of stocks. That is in large part why the Federal Reserve resorted to a series of programs to buy bonds. The idea was that this would push up asset prices and in this, at least, it worked. Compare a chart of the increases in the total amount of bonds the Fed holds on its balance sheet since the market bottom in 2009 with a chart of how stocks have performed relative to bonds and they look almost identical.
Over the past seven years, stocks have rallied relative to bonds whenever the Fed was buying bonds and fallen back whenever the Fed desisted from buying. And since the Fed started to taper off its purchases of bonds, in December 2013, bonds have beaten stocks. This year, bonds have easily outpaced stocks.
So the headline record for the US indices begins to look more like an outcrop of the far more remarkable rally in bonds, and of central bank intervention. What does that mean for the future?
Look at the chart of the S&P and this looks like a peak, and a bad time to buy. Look at the chart of how stocks have performed relative to bonds, and it looks like stocks should be ready to shine. This illustrates the paradox that has also lasted for years that stocks look expensive by almost any sensible historical measure — except when compared to bonds, when they look cheap.
But there is a nasty problem with this. If bonds finally go into reverse, rates will rise, the support for stocks will be removed and the risk is more that stocks will start to fall. The bond market rally is extraordinary, it has gone on for a long time, defeating predictions by many (myself included) that yields had become unsustainable. US Treasury yields have been falling steadily for more than three decades.
If bonds can somehow continue this, then stocks will probably continue to prosper (although they may fail to outstrip bonds). If bonds go into reverse, it would be bad news for both stocks and bonds.
And either way, the record in the S&P 500, which has created genuine wealth for those who hold it, is a sideshow besides what is happening in bond markets.