Record bond inflows mean 'stocks are a screaming buy'

Investors are moving more money than ever before out of stocks and into bonds, widening a valuation gap and convincing some major fund companies and investors that now is the time to buy equities. About $33 billion flowed out of funds owning U.S. shares this year even as the economic recovery sent free cash flow for American companies excluding banks to 6.8 percent of their market value. That's the highest level compared with corporate debt yields since 1960, Credit Suisse Group AG data show. About $185 billion was sent to bond funds through July 31, the most on record, according to the Investment Company Institute. The biggest money managers say concern the U.S. will slip into a recession is overblown and that individuals piling into fixed-income securities for their relative safety are making a mistake. David Kelly, who helps oversee $445 billion as chief market strategist for JPMorgan Funds, says record low yields show there's too much demand for bonds and aren't a sign the economy is headed for the second recession in three years. “People would rather overpay for bonds than underpay for stocks,” Kelly said in an interview from New York. “It's a reflection of an extraordinary prejudice. If people are at an emotional extreme, it means that at some point there's got to be reallocation of cash away from the bond market toward the stock market. Ultimately, it's bullish.” Weekly Decline Futures on the Standard & Poor's 500 Index were little changed at 1,075.90 as of 9:09 a.m. in London. Stocks dropped last week, with the S&P 500 losing 3.8 percent to 1,079.25, on speculation the global economic recovery is faltering. Investment-grade corporate bonds returned 0.54 percent, including reinvested interest, according to Bank of America Merrill Lynch's U.S. Corporate Master index. A four- month rally in Treasury prices pushed yields on 10-year notes down to 2.67 percent last week, compared with 4.01 percent on April 5, data compiled by Bloomberg show. The Federal Reserve on Aug. 10 reversed plans to exit from monetary stimulus and said it would keep its bond holdings level to support an economic recovery, which it said is weaker than anticipated. Cisco Systems Inc., the world's largest maker of networking equipment, forecast sales on Aug. 11 that missed analysts' estimates, while unemployment claims rose in a Labor Department report on Aug. 12. Investors have pulled money from U.S. equity funds in 10 of 17 months since the start of a rally in March 2009 that sent the S&P 500 up as much as 80 percent. This year's withdrawal, the biggest since 2008, came as worker firings and reduced capital spending pushed company cash to $836.8 billion, according to S&P. Non-financial companies are yielding 0.8 percentage point more in free cash flow than the average interest rate on investment- grade corporate bonds, according to Credit Suisse. Bond Inflows About $185.3 billion was invested in bond funds in 2010 through July 31, according to ICI. That's the most for the first seven months of any year since 1984, when ICI started compiling the data. The spending has helped push the average investment- grade bond price to more than 110 cents on the dollar, the highest level in more than six years, Bank of America Merrill Lynch index data show. “Stocks are a screaming buy relative to bonds,” said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, which oversees $342 billion. “The valuation divergence makes sense if a deflationary abyss is coming. If the economy improves, the gap will look silly.” Earnings for S&P 500 companies may rise 36 percent in 2010 and 16 percent in 2011, the largest two-year advance since the period ended in 1995, according to the average analyst projections in Bloomberg data. Economists predict a 3 percent expansion in U.S. gross domestic product this year, the fastest since 2005, Bloomberg data show. Philip Morris, EMC A moderate recovery combined with attractive valuations mean Philip Morris International Inc. and EMC Corp. are cheap enough to buy, said Keith Wirtz, the chief investment officer of Fifth Third Asset Management Inc. in Cincinnati. “Some of these equity investments are providing earnings yields that are extremely competitive relative to the bond market,” said Wirtz, who oversees $18 billion. “Given the uncertainties of 2011 on the macro picture, investors will look for returns in the large and quality segment of the market.” Philip Morris trades at 14 times reported earnings, below its record ratio of 17.6 in 2008, Bloomberg data show. The New York-based company generated $3.68 a share in free cash flow, or cash from operations left over after capital expenditures, during the past year, giving a yield of 7.1 percent. Analysts estimate earnings at the world's largest publicly traded tobacco seller, which raised its full-year profit forecast last month, to rise 15 percent this year and 10 percent in 2011. More Spending EMC, the world's biggest maker of storage computers, said last month that second-quarter profit more than doubled as businesses in the U.S. and Europe boosted spending on information technology. Its free cash flow yield is 7.7 percent, according to data compiled by Bloomberg. Hopkinton, Massachusetts-based EMC trades at 23.7 times earnings, down from 35.8 in 2007. The S&P 500 trades at 14.4 times annual earnings, compared with an average of 16.5, according to data compiled by Bloomberg that goes back to 1954. Normalized earnings-per-share growth and price-to-earnings ratios for the gauge over the next 10 years will match their median rates since 1957, said Robert C. Doll, vice chairman at BlackRock, which oversees $3.2 trillion. Doll, in an Aug. 2 statement called “10 Predictions for the Next 10 Years,” forecast that U.S. stocks will return 8.1 percent a year including dividends and the S&P 500 will almost double to 2,034 by the decade's end. He also said that returns in stocks will likely outpace U.S. Treasuries and cash. ‘More Interesting' “We'll have enough earnings growth coupled with valuations,” Doll, chief equity strategist at the New York- based firm, said in an interview. “That's an environment where stocks outperform. If the world is anything close to normal, stocks are more interesting than bonds.” While bond valuations are rising, investors are buying. The top 10 lowest-yielding U.S. corporate new issues in history have been sold in the last 14 months as yields on 2- and 3-year Treasuries fell to record lows, Deutsche Bank AG strategist Jim Reid wrote in an Aug. 4 note. International Business Machines Corp., the world's biggest computer-services company, raised $1.5 billion on Aug. 2 at the lowest interest rate on record. The 1 percent, 3-year IBM notes have the lowest coupon of the more than 3,400 securities in the Barclays Capital U.S. Corporate Index of investment-grade company debt. Johnson & Johnson sold $1.1 billion of bonds on Aug. 12 at the lowest interest rates on record for 10-year and 30-year securities. Valuation Gap The valuation gap between bonds and stocks may widen further on investor concern about deflation, said Mohamed A. El- Erian, chief executive officer of Newport Beach, California- based Pacific Investment Management Co., which runs the world's biggest bond fund. “A small increase in the probability of a deflation can have a material impact on markets even if the overall probability of the scenario remains low,” El-Erian wrote in an e-mail. “The greater the concern with deflation, the higher the vulnerability of the lower parts of the capital structure for both companies and economies. The risk premium in markets goes up disproportionately.” The Chicago Board Options Exchange Volatility Index, derived from prices investors pay to protect against losses in the S&P 500, jumped to 26.24 last week, the highest level in a month, as global stocks slumped. The VIX remains down from this year's closing high of 45.79 on May 20. “Investors have not recovered from the trauma of the financial crisis,” said Howard Ward, fund manager at Gamco Investors Inc., which oversees $26 billion in Rye, New York. “This would lead you to buying bonds, at what is likely a dangerous inflection point looking beyond the next six months, assuming no double-dip. It takes a real believer in the rewards of equity investing to commit funds in this stormy environment.”