Back to Quarterly Letters

Back to Quarterly Letters || Previous Letter || Next Letter

Quarterly Letter to Clients

October, 2010

Indices at quarter-end (September 30, 2010):

Dow Jones Industrials: 10,788.05 3Q'10 +10.37% YTD +3.45%

Standard & Poor's 500: 1,141.20 3Q'10 +10.72% YTD +2.34%

On more than one occasion I have pointed out that for 30 years, from roughly 1930 to 1960, stocks yielded more than bonds. The cause was fear; people were afraid of stocks. Over the next 50 years since 1960, though, that fear waned. It became unthinkable that stocks might sell to yield more than bonds. But today the Dow Jones yields 2.61% and the 10-year Treasury bond yields 2.52%. And again the reason is fear.

Bond yields are, quite simply, too low. The cause is at least partly that people have exited stocks in search of something that promises less damage to their financial health. The result is a stock market priced too low (at least in relation to bonds) and a bond market priced too high. Risk is rising and return is shrinking. Are we in a "bubble"? Yes, no question. But there is a difference when it comes to bonds: there is a ceiling (zero yield) and, more importantly, there is a floor--the price if held to maturity--that does not exist in other types of investments.

I have bemoaned the level of rates for several years now, and my wailings have not stopped rates from moving even lower. My error (one of timing) proves Keynes' famous line, that "markets can remain irrational longer than we can remain solvent". Is a reversal imminent? Who knows? But it is inevitable, even if we are not able to predict the timing. A reversal could take the form of stocks moving sharply higher, thus yielding less, or bonds could tumble, thus yielding more. I tend to believe the latter is the more likely scenario.

I have moved to protect my bond accounts by emphasizing shorter-term bonds; thus it is that more than half of my bond holdings mature in seven years or less. This should insulate us, at least somewhat, when rates finally start to rise. Common stocks that regularly raise their dividends also provide a little cushion.

Can rates stay this low for very much longer? They can. An example of this would be Japan over the last twenty or so years. That is not a very desirable scenario. Low rates did not help their stock or real estate markets. And anyone living off of the income from their investments would be facing a dilemma should the condition persist here in the U.S.

I am not happy buying bonds at these low rates. I recognize that if rates rise, the prices of all interest-bearing securities, including bonds and dividend paying stocks, will decline. Thus, in many accounts, cash is building up to uncomfortable levels. Now you may say that having a lot of cash is never uncomfortable, but to a money manager, it very well can be. Every day you feel the pressure of finding appropriate investments for available cash, and when there is nothing that appeals to you, and the cash keeps building up, you wonder if you are doing your job, or if perhaps you are missing some bigger picture.

But I do not believe that I am missing the bigger picture: if 10-year Treasuries are yielding only 2.52%, you are not exactly missing out on much by sitting on the sidelines. To earn more one would need to go down on the credit-quality scale, and/or go out to longer maturities. I, for one, have reached my limits on these two fronts.

Look at Microsoft: near the end of the quarter, Microsoft raised its dividend. That common stock now yields 2.6%. On the same day, Microsoft issued bonds in three tranches: three-year bonds to yield 0.875%; five-year bonds to yield 1.7%; and ten-year bonds to yield 3.1%. Microsoft is hardly alone in offering a higher yield on its common stock than on most of its bonds.

Speaking of equities, perhaps it is just that stock prices are finding a balance in relation to bond prices, but the party in the stock market has heated up. A gain of 11% in the third quarter balanced out the loss of 10% in the second and leaves us up a few percentage points on the year-to-date. From where I sit it appears that the economy is on the mend, and stock prices are confirming that view. It is not likely to be a smooth recovery, but that only means that there will be buying opportunities.

In any event, you can be forgiven if you find it hard to get excited about the advance in stocks, as it seems like the quarter-to-quarter pattern lately is a sharp advance followed by an equally steep decline. Everyone would certainly welcome a continuation of the third quarter's advance, but should that not prove to be the case, I believe it right to be a buyer of stocks on any significant pullbacks.

Jim Pappas