Bonds down, stocks down. Why?

The last week brought worldwide gyrations as bond and stock markets alike went down.

What has changed? What has not changed?

The biggest economy in the world, the United States, is still moving forward in a steady upward progression. The news out of the emerging countries is mixed as China, the largest developing economy, has shown more signs of weakness, but not recession. And in Europe, already mired in recession, the news has been better, with higher manufacturing indications from Germany and somewhat better confidence numbers in the smaller countries. None of this is earth shaking or fundamentally different than what we have been witnessing.

US stocks find support across the board

Even as economic confidence is improving, investors are worried about the rapid rise of the stock market. In fact, the question I am still most often asked is whether this market has gone too far too fast, and whether we have seen its peak.

Let’s look at some of the facts. First of all, as of June 19, the S&P 500 is up 14.2% year-to-date and 20% higher than a year ago. The Russell Value Index is up 24.9% over the last 12 months. However, I believe that fundamentals still support this market. Investors are searching for yield and thus willing to take on more risk. While this more aggressive stance could cause US stocks to become overbought, this does not yet appear to be the case. Right now, fundamentals are pretty solid, particularly in the United States, and are slightly improving overseas.

Looking for yield in all the wrong places

There is a big difference between dividend yield in stocks and the contractual yield inherent in bonds. But something interesting happened recently. The dividend yield on stocks fell below the contractual yield of the 10-year Treasury note.

More accurately, the yield of the 10-year Treasury rose above the 2% yield on the Standard & Poor’s 500 Stock Index. For investors, the yield’s rise above 2% represented a big crossover moment, which we have not seen since April 2012.

Yield to temptation

Investors are restlessly seeking return on their investments in a world where global central bankers are suppressing yield and lowering borrowing costs. They have moved up and down the risk curve in both stock and bond markets in search of this yield.

I believe investors know that the higher the yield, the higher the risk. But we all sometimes fall victim to magical thinking. Therefore it is important to review the warning signs of yield mania. Let’s take a look.