By E.S. BROWNING
WSJ.com, 29 Sep, 2008
Investors are relieved that Washington is trying to ease the financial crisis, but they aren't persuaded it will mean an end to the bear market in stocks.
The reason: They fear that the economy, the financial system and corporate profits could be facing troubles for months to come.
Instead of stocks, some money managers looking for a safer way to bet that the financial system won't crater are buying corporate bonds. The credit crisis makes it more expensive for companies to borrow, which means higher yields for investors as long as the companies remain solvent.
Many bonds rated single-A or triple-B, in the lower range of investment grade, currently yield more than 7%, even as fears of corporate failures are abating.
To get that kind of return from stocks given current prices, says Jack Ablin, chief investment officer at Harris Private Bank in Chicago, you would have to assume profit gains of 12% or more a year, based on current ratios of prices to earnings.
"Why take that risk?" Mr. Ablin says. "I would rather clip a 7.1% yield using a bond than hope for a 7.1% return from a 2% dividend yield and a hope that the stock price rises 5.1%." He says junk bonds look attractive as well, for similar reasons. Indeed, junk bonds have been yielding nearly 10 percentage points over comparable Treasurys in recent days, according to Merrill Lynch.
It is a cliche by now that the stock market moves in anticipation of economic developments. It usually begins to recover months before the economy does, looking ahead to better days. But some investors are reluctant to buy stocks because they don't yet see better days coming, and because corporate bonds are so attractive. This helps explain why stocks continued to fall last week, with the Dow Jones Industrial Average declining 245 points, or 2.2%, to 11143.13, even after gaining 121.07 on Friday.
In uncertain times, bond mavens remind clients that by choosing bonds they are being paid while they wait for the stock market to find its way, because they receive the bond's dividend.
"There will be pressure on earnings and that is a tough environment for stocks," said Kathleen Gaffney, co-manager of the Loomis Sayles Bond Fund. "The great thing about fixed income is that you are paid to wait."
The idea is that the financial crisis may be easing now, which will reduce the risk of corporate bankruptcies, especially at banks, but won't necessarily produce big gains for corporate profits. While stocks could remain in the doldrums, bondholders are likely to be repaid.
Ms. Gaffney has been moving some money out of Treasury bonds, where she had parked it for safety, and into triple-B and single-A bonds. She figures that the default risk is low now, especially if you own a broad range of bonds, and the yields are unusually high.
The sectors she prefers are those that have born the brunt of the fear, financial companies and companies that are most directly exposed to the economy's ups and downs, such as industrial companies. They offer the best yields.
"We are looking at the commercial banks," she said. She isn't buying them all, but "we think there are some survivors out there that are very attractive."
She isn't entirely ready to bet that the worst is over. She continues to hold some money in cash and Treasury bonds.
A big problem with stocks today is that analysts' corporate-profit expectations remain highly unrealistic. Analysts forecast that big companies' quarterly profits will grow at an average rate of about 26% through the first half of next year, according to Thomson Reuters. Those numbers look like fantasy, says Harris Private Bank's Mr. Ablin.
He doesn't see a bull market in stocks any time soon, and instead sees continuing economic weakness. Although higher borrowing costs hurt corporate-profit prospects, most investment-grade companies have solid balance sheets and their bonds offer inviting returns.
Citigroup economist Steven Wieting recently lowered his forecasts for big-company profits. He now expects them to fall in the current year and rise just 2.5% next year. That is not exactly fuel for a stock-market surge. Economists also are cutting their economic-growth forecasts amid weak reports on employment, home sales, industrial activity and the like.
Many money managers, such as Gordon Fowler, chief investment officer at Philadelphia money-management firm Glenmede Trust, are urging clients to maintain higher cash levels than they normally would, despite the looming Washington bailout.
"If you have a newborn child or grandchild, now is an excellent time to open a 529 college-education account and start funding it entirely with equities," Mr. Fowler wrote in a report to clients. "An investor with a 10- to 15-year time horizon could expect to earn 8% to 10% per annum. The answer is not quite as clear over the next six to 12 months."
The credit crunch also has hit the municipal-bond market, pushing yields higher as investors flee to the safety of short-term Treasurys and cash.
Analysts forecast that stocks could get a boost once Washington finalizes a bailout which lawmakers said early Sunday was imminent. Apart from that, the quarter ends on Tuesday, and some money managers who have been holding money in cash will feel the need to buy stocks now, because their bylaws require them to remain fully invested. That also could support the stock market.
Over the longer term, some analysts worry that any stock rally now will be built more on artificial government stimulus than on lasting investor confidence. They note that the current bear market has lasted as little less less than one year, and has included stock-index declines of around 25%. That is about average for a bear market -- and the blow to the financial system this time has been far greater than average.
Many money managers expect stocks to fall again, as investors "retest" the lows stocks hit earlier this month. The stock market's medium-term strength could depend on whether it rebounds from those lows, or sinks to still-lower levels, as it has done after each of the other government bailout plans so far this year.
