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Stocks Versus Bonds: One Market Is Out of Whack

Even though they rely on the same economic data and news reports in their investing decisions, the players in the U.S. stock market have a much more optimistic view of the world today than bond investors. The stock market's valuation is not outlandish, but it does anticipate strong earnings growth for corporate America in 2009 and 2010, while Treasury bonds appear to be discounting low inflation, a low demand for credit, and slower growth. One of these markets is in for an unpleasant surprise.

The U.S. stock market, as measured by the S&P 500, is up 14 percent from the start of this year, and has recovered 54 percent from the dark days of March (through August 28). Outperforming sectors include the financial stocks, which have gained 18 percent for the year; technology stocks, up 33 percent; and basic materials stocks, rising 28 percent.

Some of the year's gains were a recovery from March's panic selling, but stocks continued to rally on second-quarter earnings reports. Investors are also encouraged by profit forecasts for S&P 500 companies, estimated to be up 14 percent over the next 12 months, with the best growth foreseen in the technology, financials and consumer discretionary sectors. (This comes from StarMine, a company that collects earnings estimates and identifies which analysts are most accurate.)

Investors are already paying full price for those earnings. Based on profits of the last twelve months, the S&P 500 trades at about 18 times earnings, reports Robert Shiller, the prolific economics professor at Yale University. That's not a crazy valuation: it's close to the average p-e of 19 since 1960, but below the mid-20s range that prevailed from 2004 through early 2008, when the economy was quite strong (or so we thought) and S&P 500 earnings grew at between 15 and 20 percent. The graph below, plotting the price-earnings ratio of the S&P 500 from 1871 through August 2009, comes from Dr. Shiller's web site.

Looking forward, the valuation of the market is about 15 times profits for the year that will end June 2010, says StarMine. It's those earnings forecasts that are driving the market higher. Analysts have not raised their estimates of 2009 earnings much -- just 0.4 percent since the reports on the second quarter -- but just the confirmation that profits are on track has boosted the S&P 500 by 17 percent since early July. The stock market seems quite confident that the worst of the economic and financial crisis is behind us.

Next, what is the bond market telling us? The story is simpler. Consider first that interest rates are very low (see the graph below comparing two-year and 10-year Treasury rates). Yes, the Fed has been managing both long and short rates to keep them low, but hasn't had to exert much pressure to hold them in check.

They're low because of weak demand for credit and low inflation, signs of a slow-growth economy. Both the two-year and 10-year rates are up from the crisis levels of January 2009, but clearly very low relative to their own history. The bond market is priced for a weak economy.

To reconcile the two markets' view of the future, I reached out to people that are well-informed on such topics. But it was a Friday in late August and these are smart and successful people, so no one was around. (Actually one fellow did write back, but his comments were neither elucidating nor in good taste.)

Here's my take. Each market is operating on the relevant information available to it. When I worked on Wall Street, the bond people and stock people seldom sought each others' advice.

The bond market sees slow growth and low inflation in the recent past, and forecasts of the same for, say, the next two quarters, and arrives at low interest rates. The stock market's information sources are more elaborate: company managers and industry analysts put together stories about how the next few years will unfold. With a longer time frame they can become more optimistic, which in this market has translated to a higher valuation for stocks.

But some time soon, there will be an unexpected earnings report or economic event that will set the course for the few months following. We'll have one of two outcomes: the economy or corporate earnings will confirm or exceed the forecasts, and this will give support to stocks, but drive up interest rates and hurt bonds. Or the economy will stumble, fulfilling the bond market's outlook, but hurting stock prices.

Who's in for the disappointment? The economy may have bottomed, but I think we're in for several more slow quarters, pushing a solid recovery in profits forward in time. I think it's the stock market that will be on the hook.

Financial disclosure: I own plenty of stocks, as well as an ETF that bets against the Treasury bond market.

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