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(Scott Rothstein/iStockphoto)
(Scott Rothstein/iStockphoto)

Bonds’ caution could be bad news for stocks Add to ...

When bonds and stocks are signalling different views on the future, Brockhouse Cooper recommends listening to the bond market.

It isn’t that the bond market is necessarily smarter than the equities market; it’s just more cautious. Four months ago, Brockhouse Cooper noted that corporate credit markets were looking a little worried about the future while the stock market was riding a wave of optimism. With stocks down considerably over this period, the bond market had it right – and bonds are now suggesting more caution as the best approach going forward.

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Bullish commentators like to point out that stocks offer a more attractive valuation than bonds. The rate on U.S. high yield corporate bonds has fallen to just 8 per cent. That’s below the 8.5 per cent earnings yield (the inverse of the price-to-earnings ratio) for the S&P 500, marking the first time in at least 25 years that stocks have beaten bonds using this valuation measure.

Brockhouse Cooper, though, believes that corporate bonds are likely to outperform stocks. Yes, investors have jumped into U.S. government bonds out of a demand for safety, driving down yields to levels that don’t exactly tantalize. But corporate bonds have largely been left out of the action. Indeed, rates on high-yield instruments have risen slightly in recent months. That’s where some of the worries about the future come from – and some of the opportunities, given that the higher yields aren’t signalling a round of defaults.

Even with the divergence, the spread between high-yield bonds and government bonds remains within the historical average. “This does not indicate a 2008-like panic in the corporate world,” Brockhouse Cooper said. Meanwhile, solid corporate balance sheets and high cash levels suggest companies should have few problems making debt payments.

The look of equities isn’t as attractive though. Brockhouse Cooper noted that analysts are still cutting their estimates more than they are increasing them. The so-called upward/downward revision ratio, at 0.65, is near the low end of the range of the past three decades.

“It is important to keep in mind that since the end of the recession, the high yield credit market has usually been a leading indicator of equities,” Brockhouse Cooper said. “Despite the recent equity pullback, there is a big divergence of opinion between corporate bondholders and equity investors. When bond and stocks investors disagree, our experience tells us that the bondholders are usually right.”

 

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