Money Matters: Stocks over bonds in inflationary environment

By Cody B. Bartlett Jr.
The Daily Record Newswire

During the second quarter of 2009, our firm noticed a fundamental disconnect between the valuation of corporate debt (bonds) and equity (stock) prices. At that time, the stock market bounced dramatically off its March 9 bottom while the credit markets had yet to thaw. The result was record high credit spreads (yield premium over a treasury to hold bonds with default risk) in the face of a stock market which had rallied more than 29 percent by April 30, 2009.

We made a tactical asset allocation decision to engage in an equity substitute strategy. Our feeling was that the credit market would have to recover to validate the extreme rally in stock prices.

Our equity substitution strategy involved investing a portion of our equity portfolios in high-yield bonds. By doing this, our clients would benefit by either experiencing great returns when corporate bonds caught up with the stock market or, if this was a false stock market rally, stock exposure would be reduced and clients would have exposure to an asset class with much less downside risk (corporate bonds).

This strategy paid off as the credit markets thawed in the coming quarters and the stock market rally was validated. This was an instance in which one sector will lag behind another related sector, which allows savvy investors to profit from the incongruence.

A similar but opposing opportunity now presents itself. Corporate bond spreads have narrowed significantly this year as investors avoided the stock market and sought yield in an environment where money markets and treasuries yield almost nothing. Not only are spreads fairly narrow but the base upon which they are measured (treasury yields) is extremely low.

This is providing the conditions for a potential corporate bond correction in which treasury yields rise and corporate spreads widen. This would result in dramatic price depreciation for corporate bonds.

Given the fact that the Fed is artificially propping up the Treasury market by keeping interest rates low, the probability of a sell off  is likely greater now than during more normal bond market conditions.

Meanwhile, the stock market is up around 8 percent this year while corporate earnings have made a remarkable rebound. I would certainly not say that equities are undervalued but the current price-to-earnings ratio is certainly fairly valued at roughly 15. This compares with a five-year average of 16.3 and a 20-year average of 20.4.

We are currently suggesting underweighting bonds and being fully or slightly over allocated to stocks. Adding stocks to a portfolio in an environment in which inflation will continue to be more of a threat will actually reduce, not increase, portfolio risk. Keep in mind that periods of high inflation are very detrimental to bond returns while stocks tend to perform well.

Any shift from divergent asset classes like stocks and bonds should be done in small increments and over long periods of time, about one to two years, but we believe that a prudent investor should begin the process of taking profits from their bond portfolio and gradually increasing equity exposure.

Within the equity portion of one’s portfolio, exposure to international equities, or domestic companies with a large portion of international revenue, will further insulate the portfolio from a weak American dollar. which is important in an inflationary environment.

Cody B. Bartlett Jr. is managing director of investments/investment strategist at Karpus Investment Management and can be contacted at (585) 586-4680.