September 25, 2010 Market Outlook

Since last week, interest rates have not moved. Despite some volatility in the stock market, it ended the week just a little above the prior week. Only bond values have moved ahead. Stocks continue to show more momentum than bonds, implying that they will continue rising in the near term. It’s interesting to note that, over the course of 2010, bonds and stocks have turned in the same performance, about 3.5% YTD. The experience, of course, has been far different. Stocks have varied wildly from as high as +4.5% to as low at -5.5%. Bonds have been relatively stable, varying between +3.5% and – 1.4%. So, for someone buying index-based ETFs, the choice between stocks and bonds hasn’t affected their return, only the path taken to get here. On the other hand, what is the probably expectation of performance in future?

With interest rates at a low level, near 1.5% short term and near 3.5% long-term, there is little room to profit from bonds. The interest income will cover inflation and taxes (probably), but not provide any real return. Worse, interest rates have very little room to fall further. As rates rise, bond values fall, incurring a capital loss if sold before maturity.It seems likely that bonds will produce a negative real return if purchased for trading.

It isn’t obvious that stocks will perform better, although it seems probable. The TSX, at Friday’s close, had a P/E of 20.26 and a dividend yield of 2.66%. With the P/E at that level, it seems that it would be difficult to realise a capital gain. It’s unlikely that people will pay a higher price for stocks, at constant earnings. However, if earnings improve, a constant P/E will translate to higher prices. There’s no guarantee, but it seems more likely that earnings are improving (given earnings reported over the last two quarters) than that interest rates will increase. Further, the yield of the overall market, at 2.66%, is equivalent to medium-term bond yields. Bond principal is guaranteed, but stock ownership offers the opportunity for capital gains. In the case where the income is equivalent, even though safety of principal may align closer to some people’s objectives, the opportunity for capital gains will probably translate to better total financial performance.