David Rosenberg S&P 500, econ growth is 5%; corporate bonds,2.5%

When to switch between bonds and stocks
Panelists' advice; Bond yields and share prices tend to move together
By David Pett, Financial PostJanuary 8, 2010
The U.S. bond market will be an essential key to investing well in the coming years, not only as an place to buy, but also as a gauge of the future performance of equities.

"It has been a world of very low returns and very high volatility," said Peter Gibson, managing director of portfolio strategy & quantitative research at CIBC World Markets.

"You can make a lot of money in this environment, but it is very important to understand the principles that govern investment timing and for me the most important principle is the bond yield," Mr. Gibson told the Empire Club of Canada's annual forecast luncheon in downtown Toronto yesterday.

Since the stock market low in 1998, the S&P 500 has averaged a return of just 1.44% before inflation with huge swings in value that included rallies of 57%, 94% and 70% and drops of 50% and 57% over different periods of time. Indeed, two of the largest stock market collapses in the past 159 years have occurred since 2000.

Over the same period, bonds returned an average of 6.4% and Mr. Gibson said the ability of investors to maximize their gains is largely determined by knowing when to enter or exit one market or the other.

"In general, when the stock market is rising, the bond yield is rising and when it gets to the ceiling the bond yield is falling and the stock market is falling," he said.

"These two have moved in almost lock step for a large part of the past 10 years. Whether at the floor or the ceiling, the level of the bond yield largely defines the rate of return on the market."

Mr. Gibson explained that U.S. Federal Reserve policy tries to subtly manage bond yields, letting them rise to a point during periods of economic growth. In general they want to manage them lower, while making sure they don't fall indefinitely.

As a result, bond yield tends to seesaw within a particular range. On the high end, it's time to get out of stocks and hide in bonds. On the low end, its time to get out of bonds and get into stocks.

"The pattern is very clear," he said. "How far the rise in bond yield goes will determine how long the Fed has before it will be forced to tighten again.

The yield on the U.S. 10-year treasury closed yesterday at 3.8%. For Gibson, the acceptable range for the 10-year U.S. treasury yield today is 4.3% to 4.6% on the high end, with a level below 4%, a better place for the Fed and 3.3% representing an extremely attractive level for the Fed. The yield on the U.S. 10-year treasury closed yesterday at roughly 3.8%.

"The length of the equity rally is dependent on how long it takes for bond yields to hit the ceiling. Once it does, investors in stocks should reverse course," he said.

David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, also took the occasion of yesterday's Empire club event to emphasize the importance of bond markets on future returns.

The well-known equity bear thinks U.S. treasuries will continue to perform despite the consensus view to the contrary, but it's the market for corporate bonds that investors should keep their eye on right now.

He noted that the S&P 500 is currently discounting economic growth south of the border to hit 5%, double the expectations of his forecast and those from Canada's five top banks. At the same time, corporate bonds are discounting a more realistic growth rate of 2.5%.

"Corporates are fair value right now. If I'm wrong and we get 5% GDP growth, then all the better, corporate spreads will come in another 75 basis points. I think risk for reward, that's the place to be."